Notes on Partnership Accounting
Nature and Formation of Partnerships
A partnership is a business entity formed by two or more persons (usually up to 20) with a view to
making a profit.
Legal Context
● Governing Law: Partnerships in the Caribbean are largely based on the Partnership Act 1890.
● The Partnership Deed: This is a legal document that governs the internal operations. Without it,
the Act assumes:
○ Profits/Losses are shared equally.
○ No interest is allowed on capital.
○ No salaries are paid to partners.
○ 5% interest is allowed on loans made by partners to the firm.
Accounting for Formation
When partners bring assets into a new firm, they are recorded at agreed values (Fair Value).
● Journal Entry: * Debit: Various Assets (at agreed value)
○ Credit: Various Liabilities (if taken over)
○ Credit: Partner’s Capital Account (the balancing figure)
Appropriation of Profits
Unlike a sole trader, partnership profit must be split according to the agreement. This is done in the Profit
and Loss Appropriation Account.
The Sequence of Distribution:
1. Net Income: Start with the net profit from the P&L account.
2. Interest on Drawings (Addition): Charged to partners to discourage excessive withdrawals. This
increases the total profit available for distribution.
3. Partner Salaries (Deduction): Rewarding partners for their time and management.
4. Interest on Capital (Deduction): Rewarding partners for the risk and amount of capital invested.
5. Residual Profit/Loss: The final remaining amount is split among partners based on their
Profit-Sharing Ratio.
Admission of a New Partner
Admission of a new partner changes the ownership structure and requires the revaluation of existing
assets.
A. The Bonus Method
The Bonus Method assumes that the total capital of the new firm is the sum of the old capital plus the new
cash/assets invested.
● If Investment > Capital Credit: A bonus is paid to the Existing Partners.
● If Investment < Capital Credit: A bonus is granted to the New Partner.
● Calculation:
1. Calculate Total New Capital (Old Capital + New Investment).
2. Multiply Total New Capital by the New Partner’s % share.
3. Compare this to the actual amount they paid to find the "Bonus."
B. The Goodwill Method
This method recognizes that the business is worth more than its physical assets.
● Valuation: Usually based on the new partner’s investment. If a partner pays \$20,000 for a 1/4
share, the implied value of the whole firm is \$80,000.
● Recognition: If the existing capital + new investment is only \$70,000, then \$10,000 of Goodwill
must be recorded.
● Journal Entry: Debit Goodwill \$10,000; Credit Old Partners' Capital in their old ratio.
Retirement or Death of a Partner
When a partner leaves, the business must determine their "interest" (the total amount owed to them).
Steps in Retirement:
1. Revaluation of Assets: Assets like land, buildings, and inventory are adjusted to market value.
2. Update Capital Accounts: Credit the retiring partner with their share of revaluation gains,
undistributed profits, and goodwill.
3. Settlement:
○ Cash Payment: The firm pays the full balance.
○ Transfer to Loan Account: If cash is unavailable, the balance becomes a liability (Loan
from Retired Partner) which the firm pays back with interest.
Dissolution of a Partnership
Dissolution is the "winding up" of the firm. All assets are sold, and the business ceases to exist.
The Realization Account
This temporary account summarizes the gain or loss on the sale of assets.
1. Transfer Assets: Debit Realization Account; Credit individual Asset accounts (at book value).
Note: Do not transfer Cash.
2. Asset Sale: Debit Cash/Bank; Credit Realization Account with the actual proceeds.
3. Dissolution Expenses: Debit Realization; Credit Cash.
4. Distribution of Gain/Loss: The balance of the Realization account is closed to the Partners'
Capital accounts in their profit-sharing ratio.
Order of Payment:
1. External Creditors (Suppliers, Bank Loans).
2. Partner Loans (loans made to the firm beyond their capital).
3. Partners' Capital Accounts (the remaining cash).
Partner Insolvency
In some dissolutions, a partner may end up with a Debit Balance in their capital account (they owe the
firm money). If that partner is insolvent (cannot pay), the other partners must absorb the loss.
● Standard Practice: Previously, this was treated as a normal trading loss.
● The Rule: Under Garner vs. Murray, the deficiency of the insolvent partner is shared by the
solvent partners in the ratio of their last agreed capital balances. This protects partners with larger
capital stakes from being unfairly burdened by an insolvent partner’s debt.
Conversion to a Limited Company
A partnership may convert to a corporation to gain limited liability or access more capital.
● The Purchase Consideration: The total price the new company "pays" for the partnership.
● Accounting Treatment: * A Realization Account is used to close the partnership books.
○ The new company issues Shares or Debentures to the partners.
○ Partners' Capital accounts are closed when they receive these shares/debentures.
Comparison of Methods for Entry/Exit
Feature Bonus Method Goodwill Method
Total Assets Only physical assets + new cash An intangible asset (Goodwill) is
recorded. added.
Partner Capital Adjusted between partners Increased for all (or old) partners.
(Internal transfer).
Impact on Future P&L No amortization required. Goodwill might be amortized or
tested for impairment.