15.2: Describe How a Partnership Is Created, Including the Associated Journal Entries (2024)

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The landscaping partnership is going well and has realizedincreases in the number of jobs performed as well as in thepartnership’s earnings. At the end of the year, the partners meetto review the income and expenses. Once that has been done, theyneed to allocate the profit or loss based upon their agreement.

Allocation of Income and Loss

Just like sole proprietorships, partnerships make four entriesto close the books at the end of the year. The entries for apartnership are:

Debit each revenue account and credit the income sectionaccount for total revenue.
Credit each expense account and debit the income sectionaccount for total expenses.
If the partnership had income, debit the income section for itsbalance and credit each partner’s capital account based on his orher share of the income. If the partnership realized a loss, creditthe income section and debit each partner’s capital account basedon his or her share of the loss.
Credit each partner’s drawing account and debit each partner’scapital account for the balance in that same partner’s drawingaccount.

The first two entries are the same as for a proprietorship. Bothrevenue and expense accounts are temporary accounts. The last twoentries are different because there is more than one equity accountand more than one drawing account. Capitalaccounts are equity accounts for each partner that trackall activities, such as profit sharing, reductions due todistributions, and contributions by partners to the partnership.Capital accounts are permanent while drawing accounts must bezeroed out for each accounting period.

By December 31 at the end of the first year, the partnershiprealized net income of $50,000. Since Dale and Ciara had agreed toa 50:50 split in their partnership agreement, each partner willrecord an increase to their capital accounts of $25,000. Thejournal records the entries to allocate year end net income to thepartner capital accounts.

Income Allocations

Not every partnership allocates profit and losses on an evenbasis. As you’ve learned, the partnership agreement shoulddelineate how the partners will share net income and net losses.The partnership needs to find a methodology that is fair and willequitably reflect each partner’s service and financial commitmentto the partnership. The following are examples of typical ways toallocate income:

A fixed ratio where income is allocated in the same way everyperiod. The ratio can be expressed as a percentage (80% and 20%), aproportion (7:3) or a fraction (1/4, 3/4).
A ratio based on beginning-of-year capital balances,end-of-year capital balances, or an average capital balance duringthe year.
Partners may receive a guaranteed salary, and the remainingprofit or loss is allocated on a fixed ratio.
Income can be allocated based on the proportion of interest inthe capital account. If one partner has a capital account thatequates to 75% of capital, that partner would take 75% of theincome.
Some combination of all or some of the above methods.

A fixed ratio is the easiest approach because it is the moststraightforward. As an example, assume that Jeffers and Singh arepartners. Each contributed the same amount of capital. However,Jeffers works full time for the partnership and Singh works parttime. As a result, the partners agree to a fixed ratio of 0.75:0.25to share the net income.

Selecting a ratio based on capital balances may be the mostlogical basis when the capital investment is the most importantfactor to a partnership. These types of ratios are also appropriatewhen the partners hire managers to run the partnership in theirplace and do not take an active role in daily operations. The lastthree approaches on the list recognize differences among partnersbased upon factors such as time spent on the business or fundsinvested in it.

Salaries and interest paid to partners are considered expensesof the partnership and therefore deducted prior to incomedistribution. Partners are not considered employees or creditors ofthe partnership, but these transactions affect their capitalaccounts and the net income of the partnership.

CONCEPTS IN PRACTICE

Spidell and Diaz: A Partnership

For several years, Theo Spidell has operated a consultingcompany as a sole proprietor. On January 1, 2017 he formed apartnership with Juanita Diaz called Insect Management.

The facts are as follows:

Spidell was to transfer the cash, accounts receivable,furniture and equipment, and all the liabilities of the soleproprietorship in return for 60% of the partnership capital.
The fair market value in the relevant accounts of the soleproprietorship at the close of business on December 31, 2016 areshown in Figure 15.5.

15.2: Describe How a Partnership Is Created, Including the Associated Journal Entries (5)

In exchange for 40% of the partnership, Diaz will invest$130,667 in cash.
Each partner will be paid a salary – Spidell $3,000 per monthand Diaz $2,000 per month.
The partnership’s net income for 2016 was $300,000. Thepartnership agreement dictates an income-sharing ratio.
Assume that all allocations are 60% Spidell and 40% Diaz.

Record the following transactions as journal entries in thepartnership’s records.

Receipt of assets and liabilities from Spidell
Investment of cash by Diaz
Profit or loss allocation including salary allowances and theclosing balance in the Income Section account

THINK IT THROUGH

Sharing Profits and Losses in a Partnership

Michael Wingra has operated a very successful hair salon for thepast 7 years. It is almost too successful because Michael does nothave any free time. One of his best customers, Jesse Tyree, wouldlike to get involved, and they have had several conversations aboutforming a partnership. They have asked you to provide some guidanceabout how to share in the profits and losses.

Michael plans to contribute the assets from his salon, whichhave been appraised at $500,000.

Jesse will invest cash of $300,000. Michael will work full timeat the salon and Jesse will work part time. Assume the salon willearn a profit of $120,000.

Instructions:

What division of profits would you recommend to Michael andJesse?
Using your recommendation, prepare a schedule sharing the netincome.