Partnership accounting is not governed by the SEC so it is a case of “anything goes.” Well, not quite because there is a . . .
The key issues in partnership accounting revolve around the creation of a partnership, the admission of a new partner and the liquidation of the partnership. The new partner can pay money to the old partners directly or be asked to invest in the partnership. If the latter, the transaction might involve goodwill which could be formally recognized under the goodwill method or just informally recognized under the bonus method. In the first method, the partnership is revalued; in the second method historical costs are maintained.
For a slightly more detailed treatment along with some worked examples of the creation of the partnership and the admission of new partners see http://vanbreda.org/aforum/partnerships/partnerships07.doc A separate set of worked examples on the dissolution of partners is to follow.
A partnership is created by two or more people or entities pooling their assets and agreeing to a profit-sharing plan. The assets that each partner brings are measured at fair value. The capital split is by agreement and independent of the assets that each brings. Under the goodwill method, the partnership will formally recognize an intangible such as expertise; under the bonus method only tangible assets are recognized.
Example: A brings $50,000 in cash; B brings $30,000 in cash plus marketing skills. They plan to split the capital 50:50. Under the bonus method, the partnership has $80,000 in assets, which are split $40,000 a piece. Under the goodwill method, the partnership has $100,000 in assets, which are split $50,000 a piece.
All partnerships have profit-sharing agreements. There are no conceptual issues involved here; it is merely mechanics.
Example: The partners agree to pay salaries of $20,000 and $30,000 respectively; 10% interest on their respective capital of $100,000 and $60,000; and to share any losses equally. If the partnership makes $60,000 then A gets a salary of $20,000 and interest of $10,000 while B gets a salary of $30,000 and interest of $6,000. This totals $66,000 which creates a “loss” of $6,000, which gets split equally. In other words, A gets $27,000 and B gets $33,000. Each partner then withdraws $3,500 of their capital.
|Assets||Partner A||Partner B||Income|
Admitting a new partner can be done in two ways. The new partner can pay one or more old partners for a share in which case no new money comes into the partnership. Alternatively the new partner can invest in the partnership. In either case, the new partner can pay more or less than the book value of their share, creating re-measurement issues. In all cases, one can use the bonus or the goodwill method. As a general rule:
To summarize the three possibilities in the admission of a new partner labeled C with old partners labeled AB
|Payment||Bonus method||Goodwill method|
|C's payment = Book value||No change||No change|
|C's payment > Book value||C pays bonus to AB||Partnership has value|
|C's payment < Book value||AB pay bonus C||C brings value|
Example 1: AB's book value is $75,000 and C purchases a 20% share for $20,000 paid to A and B. The book value of ABC is $75,000 of which C gets $15,000 under the bonus method. A and B's capital is reduced by $15,000 in accordance with the admission contract. In other words, they pay a bonus to C. Under the goodwill method, it would appear that C values the partnership at $100,000 (=20,000/20%). Now one adds $25,000 to the old partnership debiting the tangible assets or creating an intangible asset. The $20,000 is credited to the old partners in proportion to their profit-sharing agreement. C has capital of $20,000. Note how this follows the general rule stated above.
Bonus - purchase
|Assets||AB capital||C capital|
Goodwill - purchase
|Assets||AB capital||C capital|
Example 2: We assume now that C gains a 20% share in the partnership by investing $20,000 in the partnership. The book value of ABC is now $95,000 of which C gets $19,000 under the bonus method. C pays a bonus of $1,000 to AB in other words. Under the goodwill method, C appears to value the partnership at $100,000. One credits $5,000 to the old partnership to bring the total value up from the book value of $95,000 to the fair value of $100,000. This goodwill adjustment is credited to A and B in proportion to their profit-sharing rule. It follows that C will have capital in the ABC amounting to $20,000. Note again how this follows the general rule stated above.
Bonus - investment
|Assets||AB capital||C capital|
Goodwill - investment
|Assets||AB capital||C capital|
If a partner decides to withdraw, the remaining partners need to decide on how much to pay their departing colleague. This typically depends on a re-valuation of the assets of the partnership to their fair value. This can be entered on the books under the goodwill method or can be used just for determining the payout under the bonus method. The two methods are illustrated below. In both cases, the remaining partners decide to pay their departing colleague $16,000. This suggests that they think the partnership is worth $15,000 (=$6,000/40%) more than its book since they are willing to pay $6,000 above A's capital.
|Assets||Partner A||Partner B||Partner C|
Note that under the bonus method, the capital of the remaining partners is decreased while, under the goodwill method, the capital of the remaining partners is increased.
If a partnership decides to dissolve itself and all the assets are sold for their carrying cost, then the partners simply get paid out their capital amounts. If the assets are sold for more than their carrying cost, then there is a gain. This gain must be distributed to the partners in proportion to their profit-sharing rule - and then the partners are paid out. If the assets are sold for less than their carrying cost, then there is a loss. This loss must be distributed to the partners in proportion to their profit-sharing rule - and then the partners are paid out.
One complication in this process is if partners have either lent or borrowed money to the partnership. The books, the law, and common practice differ on the approach to take. Some suggest that the partner who is owed money is on a par with other creditors, others suggest that the partner's loan comes after the creditors are paid, but before the capital accounts are settled. Another book suggests that usual practice is to exercise the right of offset and fold the loans into the capital. In practice, one does what the partnership has decided to do as laid out in its articles!
Two factors can complicate this. First, one or more of the partners might be wiped out by the loss. If so, the remaining partners' capital must be used to cover the debit balances in the accounts of partners who have been wiped out. Consider two partners A and B with capital of 50 and 10 who share profits equally. If their assets, which have a carrying cost of 60, are disposed of for 20, they suffer a loss on disposal of 40. Sharing this equally reduces A to 30 and B to -10. A has to transfer capital of 10 to zero out B. This leaves B with capital of 20, which equals the cash available for payout and the partnership is dissolved. B gets nothing on dissolution; A gets 20.
Second, partners are responsible for the debts of the partnership. If one of the partners is bankrupted, the remaining partners must continue to meet all the debts of the partnership. The partners are not responsible for the personal debts of the partnership. On the other hand, creditors can include in the estate of a bankrupt the capital of the bankrupt partner. Assume in the example above that A and B had assets of 90 and debts of 30. Normally A and B would be jointly and equally responsible for paying off the debt. Assume, however, that B suffers personal bankruptcy and owes his creditors a further 25. The creditors are entitled to claim (only) 10 of the partnership's assets to settle (a portion) of B's debts. This will leave A with assets shrunk from 90 to 80 and the responsibility to pay off all the partnership's debts totaling 30.
Partnerships are sometimes dissolved over a period of time. Partners will want to be able to draw cash while the dissolution is occurring. A fairly standard procedure is to assume that all the non-cash assets will be sold for nothing, creating a complete loss. Once the loss has been distributed across the partners in accordance with the procedure outlined above, one has the shrunken capital of the partners, which will equal the cash on hand. This can then be paid out. Each time some of the assets are sold and more cash is generated, the procedure is repeated until the partnership is shuttered.
One complication that I have discovered is that if assets are later sold for a profit after a partner's account has been “closed out” then one has to essentially start the process over again. Stated otherwise, the installment liquidation process assumes the worst case. If things are better than expected, then partners who might not have received a share will get their fair share of the proceedings. I have yet to find a book that addresses this issue.
For a slightly longer version of this section, together with some worked examples, see my note dissolution.