Below are the key aspects of accounting for partnerships:
1. Formation of a Partnership
When a partnership is formed, each partner contributes some form of capital, which may include cash, property, or services. The capital contributions are recorded in each partner’s Capital Account.
Example of a journal entry for partner contributions:
Dr. Cr.
Cash XXX
Equipment XXX
Partner A, Capital XXX
Partner B, Capital XXX
2. Partnership Agreement
A written Partnership Agreement typically governs the terms of the partnership, specifying how profits and losses will be shared, partner responsibilities, capital contributions, salary allowances, and how the partnership will be dissolved or handled in the event of a partner's exit or death. In case of absence any partnership agreement partners must follow the “Partnership Act”
3. Capital and Current Accounts
Partners’ equity is often tracked in separate accounts for each partner. Typically, two types of accounts are maintained:
- Capital Accounts: These reflect the partners' initial and subsequent capital contributions. Capital accounts typically remain unchanged unless a partner contributes additional capital or withdraws part of their capital investment.
- Current Accounts: These are used to record each partner’s share of the profits or losses, as well as any withdrawals made during the year. The **current account** fluctuates annually, depending on profit-sharing and drawings.
For example:
- If Partner A withdraws funds during the year:
Dr. Cr.
Partner A, Current Account XXX
Cash XXX
4. Profit and Loss Appropriation
At the end of the accounting period, the partnership’s net profit or loss is appropriated among the partners based on the profit-sharing ratio agreed upon in the partnership agreement.
Profit Appropriation:
- The Profit and Loss Appropriation Account is prepared to allocate net profit to each partner.
- Interest on capital, salary allowances, and any other agreed-upon expenses are taken into account before the final division of profit.
Steps to distribute profit:
- Close the Income Statement and transfer net profit to the **Profit and Loss Appropriation Account**.
- Allocate Interest on Capital to each partner if agreed upon (this rewards partners for their capital contributions).
- Allocate Salaries to any partner if it is specified in the agreement.
- Distribute the remaining profit in the agreed-upon profit-sharing ratio.
Journal entry for interest on capital:
Dr. Cr.
Interest on Capital XXX
Partner A, Current Account XXX
Partner B, Current Account XXX
Journal entry for profit sharing:
Dr. Cr.
Profit and Loss Appropriation A/c XXX
Partner A, Current Account XXX
Partner B, Current Account XXX
5. Interest on Drawings
If partners make drawings during the year, they may be charged interest on drawings as per the partnership agreement. This reduces the partner’s share of profits.
Journal entry:
Dr. Cr.
Partner A, Current Account XXX
Interest on Drawings Income XXX
6. Admission of a New Partner
When a new partner is admitted, the existing partners may need to adjust their capital accounts and the profit-sharing ratio. The following adjustments are common:
- New capital contribution by the incoming partner.
- Revaluation of assets and liabilities to reflect fair market value.
- Goodwill is often recognized. The incoming partner may need to pay existing partners for their share of goodwill, or goodwill may be adjusted within the capital accounts.
Journal entry to record new partner’s capital contribution:
Dr. Cr.
Cash/Asset A/C XXX
New Partner, Capital Account XXX
7. Retirement or Death of a Partner
When a partner retires or passes away, their capital account must be settled. The settlement typically involves the following adjustments:
Revaluation of assets and liabilities to fair market value.
Any goodwill adjustments.
The partner’s capital account is settled by transferring it to either the Retirement Account or Estate Account if the partner has died.
Example of settlement of capital account:
Dr. Cr.
Retiring Partner’s Capital Account XXX
Cash/Bank/Loan Payable Account XXX
8. Dissolution of a Partnership
When a partnership is dissolved, all assets and liabilities must be settled. The process involves the following:
- Realization of Assets: Selling off or converting assets to cash.
- Payment of Liabilities: Paying off any external creditors.
- Distribution of Remaining Assets: Any remaining cash or assets are distributed to partners based on their capital balances.
Steps for dissolution:
Assets realized (sold off):
Dr. Cr.
Cash XXX
Asset A/C XXX
Liabilities paid:
Dr. Cr.
Liability A/C XXX
Cash XXX
Distribution of remaining balance:
Dr. Cr.
Partner A, Capital A/C XXX
Partner B, Capital A/C XXX
Cash XXX
9. Goodwill Accounting
Goodwill is often a factor when admitting or removing a partner. Goodwill can be treated in various ways:
- Goodwill Raised and Written Off: Sometimes goodwill is first recorded in the books and then immediately written off by adjusting the partners' capital accounts.
- Goodwill Paid by New Partner: If a new partner is admitted and pays for goodwill, the amount is credited to the existing partners’ capital accounts in their old profit-sharing ratio.
Key Partnership Financial Statements
- Income Statement: Shows the partnership's revenues, expenses, and net income, which will be divided among the partners.
- Partners’ Capital and Current Accounts: These track each partner's equity, contributions, profit shares, drawings, and balances.
- Balance Sheet: Reflects the assets, liabilities, and partners’ equity in the business.
By managing these processes, partnerships ensure transparency and fairness in distributing profits, capital, and liabilities among the partners.