Chapter

12-1
 CHAPTER 12
ACCOUNTING FOR
PARTNERSHIPS

Chapter
12-2
 PARTNERSHIP FORM OF
ORGANIZATION
A partnership is an association of two or
more persons to carry on as co-owners of a
business for profit.
Type of Business:
Small retail, service, or manufacturing
companies.
Accountants, lawyers, and doctors.

Chapter
12-3
 CHARACTERISTICS OF
PARTNERSHIPS
Association of Individuals
Legal entity.
Accounting entity.
Net income not taxed as a separate entity.
Mutual Agency
Act of any partner is binding
on all other partners, so long
as the act appears to be
appropriate for the partnership.
Chapter
12-4
 CHARACTERISTICS OF
PARTNERSHIPS
Limited Life
Dissolution occurs whenever
a partner withdraws or a new
partner is admitted.
Dissolution does not mean the business
ends.
Unlimited Liability
Each partner is personally
and individually liable for
Chapter
12-5
all partnership liabilities.
 CHARACTERISTICS OF
PARTNERSHIPS
Co-ownership of Property
Each partner has a claim
on total assets.
This claim does not attach
to specific assets.
All net income or net loss is shared equally
by the partners, unless otherwise stated in
the partnership agreement.
Chapter
12-6
 ORGANIZATIONS WITH
PARTNERSHIP CHARACTERISTICS
Special forms of business organizations are
often used to provide protection from
unlimited liability.

Special partnership forms are:

1. Limited Partnerships,
2. Limited Liability Partnerships, and
3. Limited Liability Companies.

Chapter
12-7
ADVANTAGES AND DISADVANTAGES
OF A PARTNERSHIP

Chapter
12-8
 PARTNERSHIP AGREEMENT
(Articles of Co-partnership) Should specify
relationships among the partners:
1. Names and capital contributions of partners.
2. Rights and duties of partners.
3. Basis for sharing net income or net loss.
4. Provision for withdrawals of assets.
5. Procedures for submitting disputes to arbitration.
6. Procedures for the withdrawal or
addition of a partner.
7. Rights and duties of surviving partners
Chapter
12-9
in the event of a partner’s death.
 FORMING A PARTNERSHIP
Each partner’s initial investment in a
partnership is entered in the partnership
records.
The partnership should record these
investments at the fair value of the assets
at the date of their transfer to the
partnership.
All partners must agree to the values
assigned.
Chapter
12-10
 FORMING A PARTNERSHIP
Illustration: Assume that A. Rolfe and T. Shea
combine their proprietorships to start a
partnership named U.S. Software. Rolfe and Shea
have the following assets prior to the formation of
the partnership.

Chapter
12-11
 FORMING A PARTNERSHIP
Illustration: Prepare the entry to record the
investment of A. Rolfe.
Cash 8,000
Office equipment 4,000
A. Rolfe, Capital 12,000
Prepare the entry to record the investment of
T. Shea.
Cash 9,000
Accounts receivable 4,000
Allowance for doubtful accounts 1,000
T. Shea, Capital 12,000
Chapter
12-12
 FORMING A PARTNERSHIP
After formation of the partnership, the
accounting for transactions is similar to
any other type of business organization
The steps in the accounting cycle for a
proprietorship also apply to a
partnership.
There are only minor differences in
journalizing and posting closing entries
and in preparing financial statements,
Chapter
12-13
 DIVIDING NET INCOME OR
NET LOSS
Partners equally share net income or net loss
unless the partnership contract indicates
otherwise.
Closing Entries:
Close all Revenue and Expense accounts to
Income Summary.
Close Income Summary (Debit or Credit) to
each partner’s Capital account for his or her
share of net income or loss.
Close each partners Drawing account to his
or her respective Capital account.
Chapter
12-14
 DIVIDING NET INCOME OR
NET LOSS
 Illustration: Assume that AB Company has net
income of $32,000 for 2012. The two partners,
L. Arbor and D. Barnett, share net income and
net loss equally. Drawings for the year were
Arbor $8,000 and Barnett $6,000. The last two
closing entries are:

Chapter
12-15
 DIVIDING NET INCOME OR
NET LOSS

Chapter
12-16
 DIVIDING NET INCOME OR
NET LOSS
Assume that the beginning capital balance is $47,000
for Arbor and $36,000 for Barnett. After posting the
closing entries, the capital and drawing accounts will
appear as shown as below:

Chapter
12-17
 DIVIDING NET INCOME OR
NET LOSS
Income Ratios
Partnership agreement should specify the basis for
sharing net income or net loss. The typical income
ratios are:
1. Fixed ratio (A proportion, percent, or fraction).
2. Ratio based on capital balances (Beginning/average)
3. Salaries to partners and remainder on a fixed ratio
4. Interest on partners’ capital balances and the
remainder on a fixed ratio.
5. Salaries to partners, interest on partners’ capital,
Chapter
12-18
and the remainder on a fixed ratio.
 DIVIDING NET INCOME OR
NET LOSS
 Fixed Ratio:
 Easy to apply
 May be an equitable basis in some circumstances
 Assume, for example, that Hughes and Lane are
partners. Each contributes the same amount of
capital, but Hughes expects to work full-time in
the partnership and Lane expects to work only
half-time. Accordingly, the partners agree to a
fixed ratio of 2/3 to Hughes and 1/3 to Lane

Chapter
12-19
 DIVIDING NET INCOME OR
NET LOSS
 Ratio based on capital balances:
 Appropriate when the funds invested in the
partnership are considered the critical factor
 May also be equitable when the partners hire a
manager to run the business and do not plan to
take an active role in daily operations.
 Salaries to partners and Interest on partners’
capital are not expenses of the partnership.
 So, these items do not enter into the matching of
expenses with revenues and determination of net
Chapter
income or net loss.
12-20
 DIVIDING NET INCOME OR
NET LOSS
 Salaries, Interest, and Remainder on a Fixed
Ratio:
 The partnership must apply salaries and
interest before it allocates the remainder on
the specified fixed ratio—even if the provisions
exceed net income, or the partnership has
suffered a net loss for the year
 The partnership’s income statement should show,
below net income, detailed information
concerning the division of net income or net loss.
Chapter
12-21
 DIVIDING NET INCOME OR
NET LOSS
Illustration: Sara King and Ray Lee are co-partners in
the Kingslee Company. The partnership agreement
provides for: (1) salary allowances of $8,400 to King
and $6,000 to Lee, (2) interest allowances of 10% on
capital balances at the beginning of the year, and (3)
the remainder equally. Capital balances on January 1,
2012 were King $28,000, and Lee $24,000. In 2012,
partnership net income is $22,000.
Instructions:
a) Prepare a schedule showing the distribution
of net income.
Chapter
12-22
b) Journalize the allocation of net income.
 DIVIDING NET INCOME OR
NET LOSS
Division of net income schedule

Chapter
12-23
 DIVIDING NET INCOME OR
NET LOSS
Journalizing the allocation of income.

Dec. 31 Income summary 22,000

Sara King, Capital 12,400
Ray Lee, Capital 9,600
(To close net income to
partners’ capital)

Chapter
12-24
 DIVIDING NET INCOME OR
NET LOSS
Illustration: Prepare a schedule showing the
distribution of net income assuming net income is
only $18,000.

Chapter
12-25
 PARTNERSHIP FINANCIAL
STATEMENTS
• The financial statements of a partnership are
similar to those of a proprietorship.
The differences are due to the number of
owners involved.
• The owners’ equity statement for a partnership
is called the partners’ capital statement.
It explains the changes in each partner’s
capital account and in total partnership
capital during the year.
Chapter
12-26
 PARTNERSHIP FINANCIAL
STATEMENTS

As in a proprietorship, partners’ capital

may change due to (1) additional investment,
(2) drawing, and (3) net income or net loss.
Chapter
12-27
 PARTNERSHIP FINANCIAL
STATEMENTS

The balance sheet for a partnership is the

same as for a proprietorship except for the
Chapter
12-28 owner’s equity section.
 LIQUIDATION OF A
PARTNERSHIP
• Ends both the legal and economic life of the entity.
• In liquidation, sale of noncash assets for cash is
called realization.
• To liquidate, it is necessary to:
1. Sell noncash assets for cash and recognize a
gain or loss on realization.
2. Allocate gain/loss on realization to the partners
based on their income ratios.
3. Pay partnership liabilities in cash.
4. Distribute remaining cash to partners on the
basis of their capital balances.
Chapter
12-29
 LIQUIDATION OF A
PARTNERSHIP
• Each of the steps must be performed in sequence.
The partnership must pay creditors before
partners receive any cash distributions.
Also, an accounting entry must record each
step.
• When a partnership is liquidated, all partners may
have credit balances in their capital accounts.
This situation is called no capital deficiency.

Chapter
12-30
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency
Illustration: Assume that the Ace Company is
liquidated when its ledger shows following assets,
liabilities, and owners’ equity accounts.

Chapter
12-31
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency
 Assume that the partners of Ace Company
agree to liquidate the partnership on the
following terms:
1. The partnership will sell its noncash assets to
Jackson Enterprises for $75,000 cash.
2. The partnership will pay its partnership
liabilities.
3. The income ratios of the partners are 3: 2: 1,
Chapter respectively.
12-32
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency
 Ace sells noncash assets (accounts receivable,
inventory, and equipment) for $75,000. The book
value of these assets is $60,000 ($15,000 +
$18,000 + $35,000 -$8,000). Thus, Ace realizes a
gain of $15,000 on the sale. The entry is:

Chapter
12-33
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency
• Ace allocates the $15,000 gain on realization to
the partners based on their income ratios,
which are 3:2:1. The entry is:

Chapter
12-34
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency
• Partnership liabilities consist of Notes Payable
$15,000 and Accounts Payable $16,000. Ace pays
creditors in full by a cash payment of $31,000.
The entry is:

Chapter
12-35
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency
• Ace distributes the remaining cash to the
partners on the basis of their capital balances.
• After posting the entries in the first three
steps, all partnership accounts, including Gain on
Realization, will have zero balances except for
four accounts:
Cash, $49,000;
R. Arnet, Capital $22,500;
Chapter
P. Carey, Capital $22,800; and
12-36
W. Eaton, Capital $3,700, as shown below.
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency

Chapter
12-37
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency

Chapter
12-38
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency
•A word of caution: Partnerships should not
distribute remaining cash to partners on the
basis of their income-sharing ratios.
• On this basis, Arnet would receive three-
sixths, or $24,500, which would produce an
erroneous debit balance of $2,000.
• The income ratio is the proper basis for
allocating net income or loss. It is not a proper
basis for making the fi nal distribution of cash
to the partners.
Chapter
12-39
 LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency

Schedule of Cash Payments

• The schedule of cash payments shows the
distribution of cash to the partners in a
partnership liquidation.
• A cash payments schedule is sometimes prepared
to determine the distribution of cash to the
partners in the liquidation of a partnership
• The schedule of cash payments is organized
around the basic accounting equation.
Chapter
12-40
LIQUIDATION OF A PARTNERSHIP
No Capital Deficiency

Chapter
12-41
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
• A capital deficiency may result from recurring
net losses, excessive drawings, or losses from
realization suffered during liquidation.
• If such a partnership business is on the brink
of bankruptcy, the partners decide to liquidate
by having a “going-out-of-business” sale.
• They sell merchandise at substantial discounts,
and sell the equipment at auction
Chapter
12-42
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
Illustration: Assume that cash proceeds for Ace
Company from sale of equipment and merchandise
and collections from customers totals $42,000.
1. Prepare the entry for the realization of noncash
assets.
Cash 42,000
Accumulated depreciation 8,000
Loss on realization 18,000
Accounts receivable 15,000
Inventory 18,000
Equipment 35,000
Chapter
12-43
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency

Illustration: (2) Ace allocates the loss on

realization to the partners on the basis of their
income ratios. The entry is:

R. Arnet, Capital ($18,000 x 3/6)9,000

P. Carey, Capital ($18,000 x 2/6)6,000
W. Eaton, Capital ($18,000 x 1/6)3,000
Loss on realization 18,000
(To allocate loss on realization
Chapter
12-44
to partners)
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
Illustration: (3) Prepare the entry to record
the payment in full to the creditors.
Notes payable 15,000
Accounts payable 16,000
Cash 31,000
(To record payment of partnership
liabilities)

Chapter
12-45
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
Illustration: (4) After posting the three entries,
two accounts will have debit balances—Cash, $16,000
and W. Eaton, Capital $1,800. Two accounts will have
credit balances— R. Arnet, Capital $6,000, and P.
Carey, Capital $11,800. All four accounts are shown:

Chapter
12-46
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
• Eaton has a capital deficiency of $1,800, and
so owes the partnership $1,800.
• Arnet and Carey have a legally enforceable
claim for that amount against Eaton’s personal
assets.
• Note that the distribution of cash is still
made on the basis of capital balances. But the
amount will vary depending on how Eaton
settles the deficiency.
Chapter
12-47
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
• If the partner with the capital deficiency pays
the amount owed the partnership, the
deficiency is eliminated.
• To illustrate, assume that Eaton pays $1,800
to the partnership. The entry is:

Chapter
12-48
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
• After posting this entry, account balances
are as follows.

Chapter
12-49
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
Payment of Deficiency R. Arnet P. Carey W. Eaton
Cash Capital Capital Capital
Balances before liquidation $ 16,000 $ (6,000) $ (11,800) $ 1,800
Farley payment 1,800 (1,800)
Balance $ 17,800 $ (6,000) $ (11,800) $ -

The cash balance of $17,800 is now equal to the credit

balances in the capital accounts (Arnet $6,000 1 Carey
$11,800). Ace now distributes cash on the basis of these
balances. The entry is:

Chapter
12-50
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
• If a partner with a capital deficiency is unable to
pay the amount owed to the partnership, the
partners with credit balances must absorb the loss.
• The partnership allocates the loss on the basis of
the income ratios that exist between the partners
with credit balances.
• The income ratios of Arnet and Carey are 3: 2, or
3/5 and 2/5, respectively. Thus, Ace would make
the following entry to remove Eaton’s capital
deficiency.
Chapter
12-51
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
E12-10 (b)
Nonpayment of Deficiency R. Arnet P. Carey W. Eaton
Cash Capital Capital Capital
Balances before liquidation $ 16,000 $ (6,000) $ (11,800) $ 1,800
Allocation of deficiency 1,080 720 (1,800)
Balance $ 16,000 $ (4,920) $ (11,080) $ -

(b) R. Arnet, Capital 1,080

P. Carey, Capital 720
Eaton, Capital 1,800
(To record write-off of capital
deficiency)
Chapter
12-52
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
• After posting this entry, the cash and capital
accounts will have the following balances.

Chapter
12-53
LIQUIDATION OF A PARTNERSHIP
Capital Deficiency
• The cash balance ($16,000) now equals the sum
of the credit balances in the capital accounts
(Arnet $4,920 1 Carey $11,080). Ace records
the distribution of cash as:

(b) R. Arnet, Capital 4,920

P. Carey, Capital 11,080
Cash 16,000
(To record distribution of cash to the
partners)
Chapter
12-54