UNIT 8.

ACCOUNTING FOR PARTNERSHIPS

8.0 AIMS AND OBJECTIVES

The unit aims at discussing the accounting for partnerships such as recording investments,
computing each partner’s share of income or losses using different techniques, and recording
them to the respective capital accounts. Also, the accounting implications of dissolution and
liquidation of a partnership will be described. Having studied and worked through this
chapter you would be able to:

 define partnerships and explain their characteristics.

 describe the advantages and disadvantages of a partnership
 record the investments made by the partners in forming a partnership.
 understand and apply the various methods of dividing the income or lass of a
partnership.
 Record the admission and withdrawal of a partner(s)
 Understand and apply the steps in the liquidation of a partnership.

8.1 INTRODUCTION

In your previous course you have studied the three most dominant forms of business
organization: sole proprietorship, partnership, and corporation. For accounting purposes, each
form should be viewed as an economic unit separate from its owners, though legally only the
corporation is considered separate from its owners. In the previous section you have also
studied the basic accounting principles and practices used in accounting for a sole
proprietorship form of business organization. The accounting for corporate form of
businesses will be explained in the next unit. Therefore, the main focus of this chapter is to
acquaint the learns with the basics of accounting for partnerships. As will be explained later
in this section, the same accounting principles that are used in accounting for a sole
proprietorship are applied in partnership form of businesses. However, there are accounting
practices that are unique to partnerships. These unique accounting features relate to the

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partners’ capital and drawing accounts, division of income (or loss), and changes in ownership
of the partnership.

8.2 PARTNERSHIPS AND THEIR CHARACTERSTICS

A partnership is an association of two or more persons to carry-on as co-owners of a business

for profit. This association is based on a partnership agreement or contract known as the
articles of a partnership.
partnership.

The partnership agreement should specify the name location, and purpose of the business; the
capital contributions and duties of each partner; the methods of income and loss division; the
rights of each partner upon liquidation (winding up) of a partnership, etc.

The partnership agreement should be in writing to avoid any misunderstandings about the
formation, operation, and liquidation of a partnership.

Characteristics of a partnership
For purposes of accounting, partnerships are treated as separate economic entities. The next
paragraphs describe some of the important features of a partnership.
A) Voluntary Association
A partnership is a voluntary association of individuals rather than a legal entity in itself.
Therefore, a partner is responsible under the law for his or her partner’s business actions with
in the scope of the partnership. A partner also has unlimited liability for the debts of the
partnership. Because of these potential liabilities, an individual must be allowed to choose the
people who join the partnership.

B) Limited Life
Because a partnership is formed by the consent of two or more partners, it has a limited life.
This means that, anything that ends the contract dissolves the partnership.

A partnership can be dissolved when (1) a new partner is admitted; (2) a partner withdraws,
retires, dies or becomes bankrupt. At this point, the remaining partners should sign a new
contractual agreement to continue the affairs of the business. In place of the old partnership a
new partnership is formed. Thus, a partnership is said to have a limited life.

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C) Unlimited Liability
Each partner is liable for all the debts of the partnership. When and if the partnership fails to
pay its debts, creditors can seize (take) each partner’s personal assets to satisfy their claims.
Therefore, partnerships creditors claims are not limited to the assets of the business, but is
extends to the personal property of the partners. Each partner, then, could be required by law
to pay all the obligations (debts) of the partnership.

Suppose, for example, the liabilities of ABC company (a partnership business) as of a certain
date is birr 600,000, however, the total properties (assets) of ABC company could only be sold
for birr 450,000. Thus, to settle creditors claims fully, the house or personal assets of the
partners may have to be sold.

D) Mutual Agency
Each partner is an agent of the partnership within the scope of the business. This means that
partner’s act to any contract is binding on the remaining partners as long as it is with in the
apparent scope of the business’ operations.

For example, a partner in a public accounting firm can bind the partnership through the
delivery of accounting services. redundent. But this partner cannot bind the partnership to a
contract for delivering (or providing) cars because it is out of the scope of the business.

E) Co ownership of partnership property

Once invested, the properties contributed by the partners become the property of the
partnership and is owned jointly by all the partners. Upon liquidation of the partnership and
distribution of assets, the partner’s claim on the assets is measured by the amount of the
balance in his/her capital account.

8.3 ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP

Advantages:
A partnership form of business ownership has the following advantages:

1. Easy and inexpensive to form than a corporation. A partnership is easy to form. It

only requires the consent of two or more parties. Two or more competent persons simply
agree to be partners in some common business purpose.

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2. Advantageous to raise a large amount of capital and managerial skill (talent) than a
sole proprietorship. Because a partnership is formed by two or more persons, it is possible
to raise a large amount of capital and managerial skill than a single owner.

3. Not subject to separate taxation as a case in a corporation because each partner reports
his/her own share of partnership income and is individually taxed, and

4. Not required to observe on many restrictive laws unlike a corporation.

Disadvantages

Partnership has the following disadvantages:

1. Partners assume unlimited liability. The liability of the partners is not limited to what
they have in the partnership, but it goes to the extent of their personal properties (assets).

2. Disadvantageous if each partner does not exercise his/her good judgment because one
partner’s act can bind a partnership into a contract.

3. Limited life. Partnerships are subject to possible termination due to many

uncontrollable circumstances such as the death of a partner.

4. The transfer of ownership from one partner to another person is difficult unless the
remaining partners approve of this

8.4 RECORDING THE FORMATION OF A PARTNERSHIP

A separate capital account is maintained for each partner in a partnership. Each partner’s
capital account is credited for the value of their investment upon formation of the partnership.

Illustration
Dr. Teklay and Dr.Mamo decided to form a partnership business, which would provide
medical services. They have been in business separately before they form the partnership.
The partnership assumed the liabilities of their separate business. The assets were valued and
recorded at their current fair market value.

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Shown below are the assets contributed and the liabilities assumed by the partnership at their
fair market value.

Dr. Teklay Dr. Mamo

Cash Birr 6.500 Cash Birr 3,300
Accounts Receivable 8,600 Accounts Receivable 4,300
Supplies 21,000 Supplies 12,000
Medical Equipment 3,000 Medical Equipment 150,000
Accounts Payable (2,300) Accounts Payable (3,200)
The journal entry on January 1, 2002 to record the investment of each partner and the
formation of the partnership would be:

2002, Jan.1. Cash 6,500

A/R 8,600
Supplies 21,000
Medical Equipment 3,000
A/p 2,300
Teklay Capital 36,800

2002, Jan.1. Cash 3,300

A/R 4,300
Supplies 12,000
Building 150,000
Accounts Payable 3,200
Mamo, Capital 166,400

8.5 DIVISION OF PARTNERSHIP INCOME AND LOSSES

A partnership’s income and losses can be distributed according to whatever method the
partners specifies in the partnership agreement. The agreement should be specific and clear,
to avoid later disputes.

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If a partnership agreement does not mention the distribution of income and losses, the law
requires that they be shared equally by all partners. Also, if a partnership agreement specifies
only the distribution of income, but is silent as to losses, the law requires that losses be
distributed in the same ratio as income.

The Income of a partnership normally has three components:

(1) return to the partners for the use of their capital – called interest on partners’ capital,
(2) compensation for direct services the partners have rendered – called partners’ salaries,
and
(3) other income for any special characteristics individual partners may bring to the
partnership or risks they may take.

The breakdown of total income into its three components helps clarify how much each partner
has contributed to the firm.

Income can be shared among the partners in one of the following ways:

1. Net income divided in a stated ratio such as:

A) equally
B) agreed upon ratio (other than equally)
C) ratio based on beginning capital balances

2. Net Income divided by allowing interest on the capital investments, salaries, or both
with the remaining net income divided in an agreed ratio.

Example
Assume that Dr. Teklay and Dr. Mamo partnership had a net income of Birr 60,000
1. A. Assume that the articles of a partnership provides equal share of Net Income or
Loss.

- In this case the capital accounts of each partner will be credited for Birr. 30,000

Income Summary-------------------------------60,000
Dr. Teklay capital-----------------------------------30,000
Dr. Mamo capital------------------------------------30,000

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 B. Net income is divided in ratio of 3.2 to Dr. teklay and Dr. Mamo respectively.

- Income summary-------------------------------------60,000
Dr. Teklay capital (3/5 X 60,000) --------------------------36,000
Dr. Mamo capital (2/5 X 60,000) ---------------------------24,000

C. Net income is divided in a ratio of partners’ capital account balances at the beginning
of the fiscal period.

Income summary ------------------------------- 60,000

 36800 
  60,000
Dr. Teklay capital 203200 -----------------------------10,860
 
 
 166400 
Dr. Mamo capital   60,000 ------------------------------ 49,134
 203200 

 36800 + 166400 = 203200

2. Net income is divided by allowing 5% interest on their beginning capital balances, a

salary of Birr. 5,000 to Dr. Teklay and the remainder is divide equally.

Net Income Division

Income to be
Dr. Teklay Dr.Mamo Total Distributed

Net income Birr, 60,000

Interest (5%) 1,840 8,320 10,160 49,840
Salary 5,000 -- 5,000 44,840
Remainder 22,420 22,420 44,840 -- 0 –
Distribution 29,260 30,740 60,000

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 Journal entry
Income summary ---------------------------- 60,000
Dr. Teklay capital ---------------------------- 29,260
Dr. Mamo capital ---------------------------- 30,740

8.6 FINANCIAL STATEMENTS FOR A PARTNERSHIP

The income statement of a sole proprietorship and that of a partnership are the same. At the
end of the period a statement of partners’ capital is prepared which summarizes the effect of
transactions on the capital account balances of each partner. The statement of owners equity
for Teklay and Mamo using assumed data and the income division shown above is illustrated
below:
Dr. Teklay and Dr Mamo
Statement of partners’ Capital
For the year Ended Dec, 31, 2002

Dr. Teklay Dr. Mamo

Capital Bal. January 1, 2002 Br. 36,800 Br. 166,400
Add: Additional investment 4,200 4,300
Total Br. 41,000 Br. 170,700
Net income distribution 29,260 30,740
70,260 201,440
Deduct: Withdrawals during the year 5,000 5,000
Capital Bal. Dec. 31, 2002 Br. 65260 Br. 196,440

NB- The balance sheet of a partnership is different from that of a sole proprietorship only
in the owner’s equity section. In the partnership business since two or more persons
owns the business, there are two or more capital accounts whereas for a sole
proprietorship there will always be one capital account.

Check Your Progress Exercise - 3

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1. Hilina and Meron agreed to form a partnership. Hilina contributed Br. 200,000 in cash
, and Meron contributed assets with a fair market value of Br. 400,000. The partnership, in
its initial year, reported net income of Br. 120,000.

Prepare the journal entry to distribute the first year’s income to the partners under each of the
following condition.

 Hilina and Meron failed to include stated ratio in the partnership agreement.
 Hilina and Meron agreed to share income and losses in a 3:2 ratio.
 Hilina and Meron agreed to share income and losses in the ratio of their
original investments.
 Hilina and Meron agreed to share income and losses by allowing 10 percent
interest on their original investments and sharing any remainder equally

8.7 DISSOLUTION OF A PARTNERSHIP

 Dissolution of a partnership occurs whenever there is change in the original

association of partners. When a partnership is dissolved, the partners lose their authority
to continue the business as a going concern. This does not mean that the business
operation necessarily is ended or interrupted, but it does mean – from a legal and
accounting standpoint – that the separate entity stops to exist.

 The remaining partners can act for the partnership in finishing the affairs of the
business or in forming a new partnership that will be a new accounting entity.

 A partnership is legally dissolved (terminated) when a new partner is admitted or an

existing partner withdraws.

8.7.1. Admission of a New Partner:

The admission of a new partner dissolves the old partnership because a new association has
been formed.

Dissolving the old partnership and creating a new one require the consent of all the old
partners and the ratification of a new partnership agreement.

When a new partner is admitted, a new partnership agreement should be prepared.

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 A new partner can be admitted into a partnership in one of two ways:

(1) by purchasing ownership right from one or more of the original

partners, or

(2) by investing assets in the partnership.

1. Admission by Purchase of Ownership Right

When an individual is admitted to a firm by purchasing ownership right from an old partner,
each partner must agree to the change. A journal entry is needed in the partnership to transfer
the ownership right purchased from the capital account of the selling partner to the capital
account of the new partner. The partnership’s assets and liabilities remain unchanged.

Suppose, for example, Sister Helen joins the partnership of Dr. Teklay and Dr. Mamo by
buying ownership right of Br. 8000 from Dr. Mamo. The entry to record the admission of
Sister Helen and the transfer of the ownership right from the capital account of Dr. Mamo to
the capital account of Sister Helen in the partnership books shown below

Journal entry
Dr. Mamo---------------------------------- 8,000
Sr. Helen --------------------------------------8,000

The price that sister Helen paid to Dr. Momo can be more or less than Br. 8,000 but that is
irrelevant as it wouldn’t be reflected in the record (books) of the partnership.

2. Admission by Investing Assets

Assume that instead of purchasing ownership right from the existing partners, Sister Helen
invested cash of Br. 80,000 into the partnership. In this case both partnership assets and total
owners’ equity are increase. The journal entry must record such an investment and the
increase in partnership assets.

Consider the following scenarios as an example:

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1- Sister Helen receives a 50% ownership right in the partnership. Assume also
that Dr. Teklay and Dr. Mamo’s capital balance were Br. 25,000 and Br. 55,000
respectively. Dr. Teklay and Dr. Mamo share income in a ratio of 2:1 respectively.

Journal Entry

Sister Helen’s capital account would be credited for Br. 80,000 i.e., (55,000 + 25,000 +
80,000) X ½.
Cash------------------------------------------80,000
Sister Helen, Capital------------------------80,000
2- Sister Helen receives a one –fourth ownership right upon admission.
Assume everything else as above. In this case Sister Helen’s capital account would be
credited for birr 40,000 ie, (Birr 25,000 + Birr 80,000) X ¼.

The difference Br. 40,000, (80,000 – 40,000) would be shared between the remaining two
partners with the income-sharing ratio.

Journal entry
Cash----------------------------80,000
Helen capital ------------------------40,000
Dr. Teklay capital --------------------- 26,667
Dr. Mamo capital --------------------- 13,333

8.7.2. Retirement or Withdrawal of a Partner

When an existing partner withdraws he/she can sell his/her ownership right or he/she can
withdraw assets from the partnership. Both options are considered below:

1. Sale of Ownership Right to the Existing Partner

When ownership right is sold by a withdrawing partner to an existing partner, the entry on the
partnership’s books transfers the retiring partner’s capital balance to the buyer’s capital
account.
Example:

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Dr. Mamo withdraws from the partnership because of a disagreement. He sells his Br. 38,333
ownership right to Dr. Teklay.

Journal entry
Dr. Mamo Capital----------------------------- 38,333
Dr. Teklay Capital ----------------------------- 38,333

The amount paid by Dr. Teklay is not recorded on the partnership books, because the
transaction involves no flow of assets to or from the partnership.

2. Withdrawal of Assets From the Partnership

When a partner withdraws he/she may be paid above or below the amount shown in his/her
capital balances.

Example:

a. Assume Dr. Mamo was paid Br. 50,000 cash when he withdraws from the partnership
of T,M&H. The capital balances of each partner were as follows as of that date:

Dr. Teklay capital ---------------------------Br. 100,000

Dr. Mamo capital --------------------------- --- 50,000
Sister Helen capital ----------------------------- 35,000
Total Equities Birr 185,000

Journal entry

Dr,Mamo capital -------------------------------- 50,000

Cash -----------------------------------------------------------50,000

b. Assume Dr. Mamo was paid Br. 56,000 instead of Br. 50,000, the excess amount of Birr
6,000 is charged to the remaining partner’s capital accounts based on the income- sharing
ratio. (Assume a 3:2:1 income-sharing ratio between Dr Teklay Dr. Mamo and Sister Helen
respectively).

Journal entry
Dr. Mamo capital ------------------------------50,000

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 Sister Helen capital ---------------------------- 1,500
Dr. Teklay capital ------------------------------ 4,500
Cash ----------------------------------------------------56,000
 The Birr 6,000 excess is shared on the basis of a 3:1 ratio, i.e., Dr. Teklay would be
charged for 6,000 X c/4 = birr 4500, and Sister Helan would be charged for
Birr 6000 X ¼= Birr 1500.

Attempt the following questions:

1. The partnership agreement for Kebede and Lema partnership does not disclose how
they will share income and losses. How would the income and losses be shared in this
partnership?

2. In January 19X1, Sisay Hailu and Gelane Jalene agreed to produce and sell Soaps.
Sisay contributed br. 240,000 in cash to the business. Gelane contributed the building and
equipment, valued at Br. 220,000 and Birr. 140,000, respectively. The partnership had an
income of Birr 84,000 during 19X1 but was less successful during 19X2, when income
was only Br. 40,000.

(a) Prepare the journal entry to record the investment of both partners in the
partnership

(b) Determine the share of income for each partner in 19X1 under each of the
following conditions:

 The partners agreed to share income equally.

 The partners failed to agree on an income- sharing arrangement.
 The partners agreed to share income according to the ratio of their capital investments
 The partners agreed to share income by allowing interest of 10% on their original
investments and dividing the remainder equally.

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  The partners agreed to share income by allowing salaries of Birr 40,000 for Sisay and
Br. 28,000 for Gelane, and dividing the remainder equally.

3. Nadew, Tezera, and Woliyi have equity in a partnership of Birr 80,000, Birr 80,000,
and Birr 120,000, respectively, and they share income and losses in a ratio of 20%, 20%,
and 60%. The partners have agreed to admit Equbay to the partnership.

Instruction:
Instruction: prepare journal entries to record the admission of Equbay to the partnership
under the following conditions:

(a) Equbay invests Birr 50,000 for 20% interest in the partnership, and a bonus is
recorded for the original partners.

(b) Equbay invests Birr 60,000 for a 40% interest in the partnership, and a bonus
is recorded for Equbay.

8.8 LIQUIDATION OF A PARTNERSHIP

Liquidation of a partnership is the process of ending the business, of selling enough assets to
pay the partnership’s liabilities and distributing any remaining assets among the partners.

Liquidation is a special form of dissolution. When a partnership is liquidated, the business

will not continue.

 A partnership may be liquidated if:

A. the objectives sought in forming the partnership has been

achieved.
B. the time period for which the partnership was formed expires
(ends)
C. newly enacted laws have made the partnerships activities
illegal,
D. the partnership becomes bankrupt.

The partnership agreement should indicate the procedures to be followed incase of

liquidation. Usually, the books (records) are adjusted and closed, with the income or loss
distributed to the partners and the assets are sold.

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The sale of the assets at the time of liquidation of a partnership is known as realization.

As the assets of the business are sold, any gain or loss should be distributed to the partners
according to the income and loss sharing ratio.

As cash is realized, it must be applied first to outside creditors. Finally, the remaining cash is
distributed to the partners in accordance with the balance of their capital accounts.

Illustration
The partnership of Resom, Sultan, and Tassew is liquidated on September 1,2002. The
income and loss sharing ratio of the partners is: Resom 40%, Sultan 35%, and Tassew 25%.
After discontinuing the ordinary business operations of their partnership and closing the
accounts, the following summary of a trial balance is prepared:

R, S And T
Trial Balance
Septamber 1, 2002

Debit Credit
Cash 10,000
Other assets 90.000
Liabilities 10,000
R. Capital 30,000
S. Capital 30,000
T. Capital ________ 30,000
Total 100,000 100,000

Based on the information on the trial balance, accounting for liquidation of R,S,
R,S, and T
partnership will be illustrated using different selling prices for the non cash assets.

Case One: Gain On Realization

Assume that Resom, Sultan, and Tassew sell all noncash assets for Birr 95,000, realizing a
gain of birr 5000, (Birr 95,000 – Birr 90,000). The gain is divided among Resom, sultan and
Tassew in the income and loss sharing ratio of 40% 35%, and 25% respectively. Then, the
liabilities are paid, and the remaining cash is distributed to the partners according to the

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balances in their capital accounts. The entries to record the steps in the liquidation of a
business are as follows:
Cash………………………………95,000
Other assets………………………….90,000
Gain on sale of assets……………….. 5,000
Entry to record the sale of non cash assets
and the recognition of gain on realization

- Gain on sale of assets…………… 5,000

R Cap. (5,000 X 40%)………………… 2.000
S Cap. (5,000 X 35%)…………………. 1,750
T Cap. (5000 X 25%)…………………...1,250

To distribute gain on realization

- Liabilities……………………….10,000
Cash………………………………..10,000

To record the settlement of partnership liabilities.

After the above entries are posted, the partners’ capital accounts shows:

R’s Beg Bal. 30,000 + 2,000 = Birr 32,000

S’s Beg Bal. 30,000 + 1,750 = Birr 31,750
T’s Beg Bal. 30,000 + 1,250 = Birr 31,250

The cash account now shows a balance of Birr 95,000 (10,000 + 95,000 – 10,000). The entry
recorded upon distribution of this cash among the partners would, therefore, be

R, capital……………………… Birr 32,000

S, capital……………………… Birr 31,750
T, capital……………………… Birr 31,250
Cash-------------------------------------95,000

To record the distribution of cash among the partners.

partners.

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Case two: Loss on Realization: No capital Deficiencies
Assume that Resom, Sultan, and Tassew sell all non cash assets for Birr 70,000, instead of
Birr 95,000, incurred a loss of birr 20,000,(Birr 90,000 – Birr 70,000)

Journal entry

-Cash --------------------------------------70,000
Loss on realization-----------------------20,00
Other Assets-------------------------------------90,000

To record the sale of the assets

-R capital---------------------- (40% X 20,000) -----------------8,000

S capital----------------------- (35,000 X 20,000) --------------7,000
T capital ---------------------- (25% X 20,000) --------------- 5,000
Loss on Realization ------------------------------------- 20,000

To distribute the loss on realization

- Liabilities ---------------------------------- 10,000

Cash -----------------------------------10,000
To record the settlement of partnership liabilities

After the above entries have been posted; the accounts show cash 70,000 R, cap. Birr22,000
S,cap. Birr 23,000 and T, cap. Birr 25,000. The entry to record the cash distribution to the
partners would, therefore, be as follows:

R cap --------------------------------- 22,000

S cap ----------------------------------23,000
T cap --------------------------------- 25, 000
Cash -------------------------------------- 70,000
Entry to record the distribution of cash to partners.

Case three: Loss on Realization with Deficiency in one Partner Capital

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- Assume the non-cash assets of R,S and T partnership are sold for only Birr
10,200, incurring a loss of Birr 79,800,( Birr 90,000 – Birr 10,200). The entries to record
the division of loss among the partners and the liquidation to this point are shown below:

Cash -------------------------------- 10,200

Loss on sale of Assets ----------- 79,800
Other Assets-------------------------- 90,000

To record the sale of assets

R capital (79800 X 40%) ----------------------31,920

S capital (79800 X 35%) ---------------------- 27,930
T capital (79800 X 25%) ---------------------- 19,950
Loss on sale of Assets ---------------------------- 79,800

To distribute loss on realization

- Liabilities ----------------------------------- 10,000

Cash ------------------------------------------------10,000

To record settlement of liabilities

At this stage of the liquidation the capital accounts of the partners have the following balances

R capital = 30,000 – 31920 = 1,920

S capital = 30,000 – 27930 = 2,070
T capital = 30,000 – 19950 = 10,050

Only Birr 10,200 cash is available (10,000 + 10200 – 10,000) for distribution to S and T while
the combined balances of their capital accounts is Birr 12,120. Therefore, additional Birr
1,920, (12120 – 10200) is needed which is the amount owed by R to the partnership.

Therefore, either R will have to pay this amount first and the cash will be distributed to S and
T, or S and T will have to share the Birr 1920 loss in their income and loss-sharing ratio of
35:25.

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Let’s assume, the loss was distributed since R couldn’t pay the amount immediately.

Journal Entries
S capital (35/60 X 1920) -------------- 1,120.00
T capital (25/60 X 1920) -------------- --800.00
R capital -------------------------------------1,920
To charge R’s capital deficiency to S and T

S, capital -----------------------------------950.00
T, capital -----------------------------------9,250.00
Cash ----------------------------------------------10,200
To record the final cash distribution to partners.

The various entries in the liquidation of R,S, and T partnership are summarized in the
following statement.

R, S, T partnership
Statement of Partnership Liquidation
For period Sept. 1-15,2002

Non cash = Liabilities + Capital

Cash + Asset
R(40%) S(35% T(25%)

Bal.before realization Birr 10,000 90,000 10,000 30,000 30,000 30,000

Sales of Assets &

Division of loss +10,200 -90,000 --- -31,920 -27,930
-27,930 19,950

Bal.after realization 20,000 -0- 10,000 (1920) 2,070 10,050

Payment of Liab. – 10,000 --- -10.000

-10.000 --- --- ---

Bal. After payment

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Of liab. 10,200 -0- -0- (1920) 2,070 10,050

Division of deficiency --- --- --- 1920 (1120) 800

Bal. After division of

Deficiency – 10,200 -0- -0- -0- 950 9,250

Dist.of cash 10,000 --- --- --- -950 -9250

Balance -0- -0- -0- -0- -0- -0 -

8.9 SUMMARY

A partnership is an association of two or more persons to carry on as co-owners of a business

for profit. This association is based on a partnership agreement or contract known as the
articles of a partnership.

A partnership form of business ownership has several characteristics. From among them are:
voluntary association, limited life, unlimited liability, mutual agency, and co- ownership of
partnership property.

The advantages of partnerships include: easy of formation, possible to raise large amount of
capital than a single owner, not subject to separate taxation, and the absence of many
restrictive laws unlike a corporation, etc.

Partnerships have also the following disadvantages: unlimited liability, mutual agency, limited
life, etc.

In accounting for partners’ investment, it is necessary to maintain separate capital and

withdrawals accounts for each partner and to divide the income and losses of the company
among the partners. When recording the investments of the partners, all noncash assets must
be recorded at their fair market value at the time they are transferred to the partnership.

A partnership income and losses can be distributed according to whatever method the partner
specifies in the partnership agreement. The agreement should be specific and clear, to avoid
later disputes.

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If a partnership agreement does not mention the distribution of income and losses, the law
requires that they be shared equally by all partners. If a partnership agreement specifies only
the distribution of income, but is silent as to losses, the law requires that losses be distributed
in the same ratio as income.

The income of a partnership normally has three components: (1) return to the partners for the
use of their capital, (2) compensation for direct services the partners have rendered, and (3)
other income for any special characteristics individual partners may bring to the partnership or
risks they may take.

At the end of each fiscal period financial statements are prepared for a partnership business.
Most of the financial statements of a partnership are the same as that of a sole proprietorship
with the exception of the owners equity section of a balance sheet.

Dissolution of a partnership occurs whenever there is a change in the original association of

partners. When a partnership is dissolved, the partners lose their authority to continue the
business as a going concern. This does not mean that the business operation necessarily is
ended or interrupted, but it does mean - from a legal and accounting stand point - that the
separate entity stops to exist. A partnership is legally dissolved when a new partner is
admitted or an existing partner withdraws.

Liquidation of a partnership is the process of ending the business, of selling enough assets to
pay the partnership’s liabilities and distributing any remaining assets among the partners.
Liquidation is a special from of dissolution. When a partnership is liquidated, the business
will not continue.

A partnership may be liquidated if: (a) the objectives sought in forming the partnership has
been achieved, (b) the time period for which the partnership was formed expires (or ends), (c)
newly enacted laws have made the partnership’s activities illegal, (d) the partnership becomes
bankrupt.

The partnership agreement should indicate the procedures to be followed incase of

liquidation. Usually, the records are adjusted and closed, with the income or loss distributed
to the partners, and the assets are sold. The sale of the assets at the time of liquidation of a

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partnership is known as realization. As the assets of the business are sold, any gain or loss
should be distributed to the partners according to the income and loss sharing ratio. As cash is
realized it must be applied first to outside creditors. Finally, the remaining cash is distributed
to the partners in accordance with the balance of their capital accounts.

UNIT 9. ACCOUNTING FOR CORPORATIONS

9.1 AIMS AND OBJECTIVES

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This unit aims at discussing different issues related to a corporate form of organization such
as the characteristics of a corporation, accounting and reporting practical for the issuance of
stocks. Treasures stocks and equity per share. After studying this chapter, you will be able to:
- describe the characteristics, advantages and disadvantages of the
corporate form of business organization
- explain the rights of stockholders and the role of corporate directions.
- differentiate among authorized, issued and outstanding shares.
- Account for the issuance of capital stock
- understand the nature of retained earnings and dividends
- account for treasury stock transactions
- know how to calculate earnings per share.

9.1 INTRODUCTION

Assume that you are planning to start a new business. Would you choose a sole
proprietorship, a partnership or a corporation? In principles of accounting 1 and previous
chapter of principles of accounting you have studied about the first two forms of business
organizations. In this chapter the importance of corporate form of organization will be
discussed.

9.2 DEFINITION OF CORPORATION

A corporation is a legal entity having an existence separate and distinct from that of its
owners. In the eyes of the law there are two persons and a corporation is an ‘artificial person’
having many of its own rights and responsibilities.

9.3 CHARACTERISTICS OF CORPORATION

Among the characteristics of a corporation are:

a) A corporation is a separate legal entity. According to the law a corporate entity may
own property in its own name, may enter into contract and responsible for its own debts.

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 a) A corporation has a legal status in court. According to the law a corporation
may sue and be sued as if it were a real person.
b) A corporation has its own charter. A corporation is created by obtaining charter
from the state in which the company is to be incorporated.
c) A corporation pays income taxes on its earnings. The income of a corporation
is subject to income taxes, which must be paid by the corporation.

9.4 ADVANTAGES OF THE CORPORATE FORM OF ORGANIZATION

A corporate entity has many advantages not available in other forms of organization. Among
the advantages are the following:

a) Continuous existence: A corporation has perpetual existence in that its continuous

existence is not dissolved by the death on retirements of any of its members.

b) No personal liability for owners: Since a corporation is a separate legal entity, the
creditors of a corporation have a claim against the assets of the corporation, not the
personal property of the owners.

c) Separation of managements from ownership: the owners of a corporation (called

stock holders or shareholders) own the corporation but they do not manage it on a daily
basis. To administer the affairs of the corporation, president and other officers are hired
for it. Thus, individual stockholder has no rights to participate in the management's
activity of the corporation unless the stockholder has been hired as a corporate officer.

d) Easily transferable ownership shares: ownership of a corporation is evidenced by

transferable shares of stocks. These shares of stocks may be sold by one investor to
another without dissolving or disrupting the business organization.

9.5 DISADVANTAGES OF CORPORATE FORM OF ORGANIZATION

Some of the disadvantages of the corporation are:

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 a) Double taxation: corporate earnings are taxed two times. The earnings are taxed first
as a corporate income taxes and again as personal income taxes if the corporation.
Distributes its earnings to stockholders.

b) Difficulties to control: since ownership is usually separated from managements,

owners are unable to exercise active control over management actions.

c) Greater regulation: since a corporation comes into existence according to the law of
the state, the law may provide for considerable regulation of the corporation’s
activities. For example, the withdrawal of funds from a corporation is subjects to
certain limits sets by law.

9.6 FORMATION OF A CORPORATION

A corporation is created by obtaining a corporate charter. The charter is given from the states
in which the corporation is to be incorporated. To obtain a corporate charter an application
called articles of incorporation are prepared by t he organizers called incorporators and
submitted to the state corporations commissioner or other designated officials. These articles
of incorporation specify the purpose of the business, its location, the names of the organizers,
the classes and numbers of shares of capital stock authorized, and the consideration to be paid
in by the organizers for their respective shares. The article of incorporation is approved by the
state and charter is issued. Once a charter is obtained a board of directors is elected. The
directors in turn hold meetings at which officers of the corporation are appointed.

9.6.1 Organization costs

In the process of incorporation, the organizers must pay for necessary costs such as payment
of an incorporation fee to the state, payment of fees to attorneys for their services in drawing
up the articles of incorporation, payment to promoters and variety of other outlays necessary
to bring the corporation into existence. These costs are charged to an asset account called
organization costs. In the balance sheets, organization costs appear under the ‘other assets’
caption.

9.6.2 Rights of Stockholders

The stockholders who are the owners of a corporate entity have the following basic rights:

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 a) The rights to votes: the common stockholders have the right to elect the board of
directors, and thereby to be represented in the management of the business.

b) The rights to participate in the earnings of a corporation: Stockholders in

corporations may not make withdrawal of company assets. However, the earnings of a
profitable corporation may be distributed to stockholders is the form of cash dividend.
The payment of a dividend always requires formal authorization by the board of
directors.

c) The rights to share in the distribution of assets upon liquid action: when a
corporation ends its existence, the creditors of the corporation must first be paid is full;
any remaining assets are dividend among stockholders in proportion to the number of
shares owned.

d) Pre-emptive rights: the current stockholders has the right to purchase the shares of the
corporation on a prorate basis when new stocks are offered for sale. This preemptive
rights is designed to provide each stockholder the opportunity to maintain a
proportional ownership in the corporation.

Check Your Progress Exercise -1

1. When a business is organized as a corporation:
a) Stockholders are liable for the debts of the business
b) Stockholders do not have to pay personal income taxes
on dividend received.
c) Each stockholder has the rights to make managerial decision.
d) Owners cannot withdraw assets from the business at will.

9.7 AUTHORIZATION AND ISSUANCE OF STOCKS

The state officials approve the articles of incorporation, which specify the number of shares a
corporation is authorized to issue. The total number of shares that may be issued is known as
the authorized shares.
shares. When the corporation receives cash is exchange for stock certificates,
which represents the number of shares issued, the shares become issued shares.
shares. Shares that

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are issued and held by the stockholders are called outstanding shares.
shares. Sometimes a
corporation requires shares from its own shareholders. These shares are called treasury
stocks,
stocks, which reduce the number of outstanding shares.

A corporation may choose not to issue immediately all the authorized shares even though it is
customary to have a large number of authorized shares than presently needed. If more capital
is needed, the previously authorized shares will be readily available for issue. A corporation
can apply to the state for permission to increase the number of authorized shares.

9.7.1 Types of Stocks/Shares

Many corporations issue several classes of capital stock, each providing investors with
different rights and opportunities. The basic types of stock issued by every corporation is
called common stock.
stock. Common stock possessed the traditional rights of ownership such as
voting rights, participation residual dividends, and residual claim to assets in the event of
liquidation. When any of these rights is modified, the term preferred stock is used. Preferred
stock specifies different rights that distinguish it from common stock. Some of the distinctive
features for preferred stocks are priority claims on dividends, cumulative dividend rights,
priority as to assets is the event of liquid action of a corporation and no voting power.

Stocks according to their nature are classified into par value and no-par stocks.
stocks. Par value
stocks with a designated dollar amount per share as stated in the corporate charter and printed
on the stock certificates. On the other hand, some states allow corporations to issue stocks
without designating a par value. Such stocks are called no-par stocks.
stocks. When no par stocks are
issued by a corporation, the entire issuance price is viewed as a legal capital, which is subject
to withdrawal. Sometimes some states authorize the issuance of no-par stock with a stated, or
assigned, value per share that is established permanently by the corporate directors and is in
the laws. Most corporations use a stated value for no par stock.

9.7.2 Issuance of Par-value Stocks

9.7.2.1 Authorization
Authorization of par value stocks, specified in the unit may be recorded as a memo entry in
the general journal and in the ledger accounts. Most states require the total number of shares

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authorized be shown on each stock certificate, in addition to the number of shares represented
by that particular stock certificates.

9.7.2.2 Par value stock issued for cash

When stocks are issued to various investors, a stock certificate specifying the number of
shares represented is prepared for each investor/or stockholder. When par value stock is issued
for cash, the capital stock account is credited with the par value of the shares issued regardless
of whether the issuance price is more or less than par. If par value stock is issued for more
than par value (at premium), paid in capital in excess of par account is credited for the excess
of selling price over par. This paid in capital is excess of par does not represent a profit to the
corporation rather it is part of the invested capital. If par value stock is sold by corporation for
less than par (at discount), a negative stockholders’ equity accounts, Discount on common (or
preferred) stock, is debited for the amount of the discount.

For example, assume that 50,000 shares of Br. 2 par value common stock have seen
authorized and that 10,000 of these authorized shares are issued at a price of Br. 10 each. The
entry would be:

Cash………………………………………………………100.000
Common Stock…………………………………..20,000
Paid-in-capital is excess of par………………… 80,000

9.7.2.3 Par value stock issued on a subscription basis

During the start-up of a corporation, prospective investors may sign a contract to purchase a
specified number of shares on credits with payments due at one or more specified future
dates. One reason for this procedure is to attract small investors. Another reason is to appeal
to investors who prefer not to invest cash until the corporation is ready to start business
operations. A corporation may also sell its capital stock on credit after incorporation.

When stock is subscribed, the company debits stock subscription receivable for the
subscription price, credits capital stock subscribed for the par value of the subscribed shares,
and credits paid in capital in excess of the subscription price over par value. Later, as cash is
collected, the entry is a debit to cash and a credit to stock subscription receivable. When the

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entire subscription price is collected, the stock certificates are issued for the subscribers. The
issuance of stock is recorded by debiting capital stock subscribed and crediting capital stock.
The following illustration demonstrates the accounting procedures for stock subscriptions.

Assume that 120,000 shares of RAM corporation common stock, par br. 10, are subscribed for
at Br. 12 by Misrak Binda. The total is payable in three installments. The following entries are
processed by RAM Corporation.

Common stock subscription Receivable 1,440,000

Common stock subscribed 1,200,000
Paid-in-capital in excess of par 240,000
To record receipt of subscription for 120,000 shares
Cash 480,000
Common stock subscription receivable 480,000
To record receipt of 1st payment
Cash 480,000
Common stock subscription Receivable 480,000
To record receipt of final payment
Cash 480,000
Common stock subscription Receivable 480,000
To record receipt of final payment
Common stock subscribed 1,200,000
Common stock 1,200,000
To record issuance of stock

9.7.2.4 Non Cash Issuance of Capital Stock

Corporations sometimes issue capital stock for non-cash assets such as in exchange for real
estate. The current markets value of the stock issued or the non-cash consideration received,
whichever is must reliable, determinable, is used to record the transaction. If the market value
of either capital stock issued or the no cash items are not reliable, the value are established by
the corporation’s board of directors.

9.7.2.5 Issuance of No-par Stock

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Some states allow corporations to issue stock without designating a par or stated value. When
this no par stock is issued, the entire issuance price is credited to the capital stock account and
is viewed as legal capital not subject to withdrawal.

9.8 ACCOUNTING FOR RETAINED EARNINGS AND DIVIDENDS

9.8.1 Nature of Retained Earnings

Capital provided to a corporation by stockholders in exchange for shares of either preferred or
common stock is called paid in capital or contributed capital.
capital. The second major type of
stockholders’ equity is a retained earnings. The amount of the retained earnings account at any
balance sheet date represents the accumulated earnings (net income) of the company since the
date of incorporation, less any losses and all dividends distributed to stockholders.

9.8.2 Nature of Dividends

A dividend is a distribution of earnings to stockholders is the form of assets or shares of the
issuing company’s stock. Type of dividends includes the following.
a) Cash dividend
Cash disbursed
b) Property Dividend
Non cash assets disbursed
c) Stock Dividend
Corporations own stock disbursed
d) Liquidating Dividend
Return of contributed capital
e) Scrip Dividend
Creation of a liability by declaring a dividend to be paid at a specific future date.

9.8.3 Relevant dividend dates

Prior to payment, dividends must be declared by the board of directors of the corporation. The
important dividend dates are:
a) Date of Declaration: on this date, the corporation’s board of directors formally
approves and announces the dividend to be distributed. The declaration is recorded on
this date as a debit to dividends and a credit to dividends payable.

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 b) Date of payment: this date is determined by the board of directors and is usually stated
is declaration. At the date of payment the liability recorded at the date of declaration is
debited and the appropriate asset account is credited.

9.8.4 Dividend and Characteristics of preferred stock

A corporation with both preferred stock and common stock may declare dividends on the
common only after it meets the requirements of the stated dividend on the preferred. The
preferred dividend may be stated in monetary terms or as a percent of par.

9.8.4.1 Participating and non-participating preferred stock

A participating preferred stock receives a minimum dividend but also receives higher
dividend when the company pays substantial dividends on common shares. The preferred
stockholders’ right may be to receive dividend only a stated amounts. Such stock is said to be
nonparticipating.

To illustrated, assume the following information

 Common stock issued 4,000

 Preferred stock issued 2,000
 Dividend per share of preferred stock Br. 10

The corporation reported net income of Br. 150,000 for the third year and the BOD declared
both of the net income as dividend. If the preferred stock issued by the corporation is
participating, the preferred stockholders will receive. Br. 30,000 (Br. 20,000 + Br. 10,000),
and the common stockholders will receive Br. 60,000 (Br. 40,000 + Br. 20,000).

9.8.4.2 Cumulative and Non-cumulative preferred stock

Cumulative preferred means that if the company fails to pay a preferred dividend, its
obligation accumulates and all omitted dividends must be paid in the future before any
common dividends are paid. The cumulative preferred stockholders would receive all
accumulated unpaid dividends (called dividend in arrears) before the holders of common
shares receive anything. Preferred stock not having this cumulative rights is called no
cumulative.

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For example, assume the following information
 Cumulative preferred, 10% of Br. 100 par (10,000 shares issued)
 Common stock of Br. 90 par (40,000 shares issued)
 The Board of Directors (BOD) did not declare dividend in year 2
 Year 3 dividend declared by the BOD amounts to Br. 320,000.
 Year 1 dividend declared and distributed amounts to Br. 200,000.
If the preferred stock is cumulative, the preferred stockholders will receive Br. 200,000 (Br.
100,000 + Br. 100,000), and the common stock holders will receive Br. 120,000 (Br. 320,000
– Br. 200,000).

Check Your Progress Exercise –2

1. State the classification (assets, liability, stockholders’ equity, revenue
or expense) of each of the following accounts
a) subscription receivable
b) organization costs
c) paid in capital is excess of par value
d) retained earnings
e) preferred stock

2. If a corporation has outstanding 1,000 shares of Br. 9 cumulative

preferred stock of Br. 100 par and dividends have been passed for the preceding three
years, what is their amount of preferred dividends that must be declared is the current year
before a dividend can be declared on common stock?
a) Br. 9,000 c) Br. 36,000
b) Br. 27,000 d) None

9.9 ACCOUNTING FOR TREASURY STOCKS

Treasury stock is a corporation’s own stock (preferred or common) that has been issued and
required by the issuing corporation. A corporation may also accept shares of its own stock in
payment of a debits owed by a stockholder or as a donation from a stockholder.
Treasury stock does not reduce the number of shares issued, but does reduce the number of
outstanding shares. The purchase of treasury stock decreases both assets and stockholders’

32
equity. Moreover, treasury stock does not carry voting, dividend, preemptive, or liquidating
rights and is not assets.

9.9.1 Reasons to acquire Treasury Stocks

In general treasury steps are to acquire for the following reasons:
a) to support (increase) the markets price of the stock
b) to I increase earnings par share by reducing the number of shares outstanding.
c) To reduce dividend payment payments by reducing the number of shares outstanding.
d) To provide shares for reassurance to employees as a bonus
e) To use the share acquired for stock dividend
f) To reissue with a higher price

9.9.2 Recording and reporting Treasury stock Transactions

There are several methods of accounting for the purchase and the resale of treasure stock. A
commonly used method is the cost basis. When the stock is purchased by the corporation,
treasury stock account is debited for the price paid for it. The par and the price at which the
stock was originally issued are ignored. When the stock is resold, treasury stock is credited at
the price paid for it, and the difference between the price paid and the selling price is debited
or credited to an account entitled paid in capital from sale of treasury stock.

To illustrate the cost method, assume that Harambe Corporation had 50,000 shares of Br. 10
par common stock outstanding at the beginning of the current year. The company purchased
500 shares for cash and received 500 shares in settlement of a debt from stockholders. The
markets price of stocks was Br. 30/share. The following entry is required involving the
transactions.

Treasury stock 30,000

Cash 15,000
Notes Receivable 15,000

If the company sells 600 shares of the treasury stock for Br. 31 each, the entry would be:
Cash 18,600

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 Treasury stock 18,000
Paid in capital from sale of 600
Treasury stock

Paid in capital from sale of treasury stock is reported in the paid in capital section of the
balance sheet. Treasury stock is deducted from the total of the paid in capital and Retained
earnings.

9.10 EQUITY PER SHARE

The amount appearing on the balance sheet as total stockholders’ equity can be stated in terms
of the equity per share. When there is only one class of stock, the equity per share is
determined by dividing total stockholders’ equity by the number of shares outstanding. For a
corporation with both preferred and common stock, it is necessary first to allocate the total
equity between the two classes. To illustrate, consider the following statements of
stockholders’ equity at December 31, 19x1.

- 9 to preferred stock, Br. 50 par value, authorized 20,000 shares, issued and
Outstanding 12,000 share Br. 600,000

- Common stock, no par, stated value Br. 2 per share,

authorized 500,000 shares, issued 400,000 shares of which 25,000
shares are held is the treasury 800,000

- Paid in capital is excess of per

-Preferred Br. 50,000
-Common 1,000,000 1,050,000
- Retained earnings 2,000,000
Subtotal Br. 4,450,000

- Less cost of 25,000shares of common stock

Reacquired and held in treasury 250,000
- Total stockholders’ equity Br. 4,200,000
If the preferred stock is entitled to receive Br. 105 per share upon liquidation and if there is no
preferred dividend in arrears, the computation of earnings per share are as follows:

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Preferred EPS = Equity allocated to preferred stock
Number of o/s shares of preferred stock
= 105 X 12,000
12,000
= Br. 105/share
105/share

Common EPS = Equity allocated to common stock

Number of o/s shares of common stock
= 2,940,000
375,000
= Br.
Br. 7.84 /share

9.11 SUMMARY

 A Corporation has the following most important

characteristics:
 Separate legal existence, limited liability, and
transferable units of stocks.

 The primary advantages of a corporation are no

personal liability of stockholders for the debts of the business, the transferability of
ownership shares, continuity of existence and ability to hire professional managements.

 Stockholders in a corporation normally have the

rights to elect the board of directors, to share in dividends declared by the directors, to
share is the distribution of assets if the corporation is liquidated, and to subscribe to
additional shares if the corporation decides to increases the number of shares outstanding.

 Common stock represents the true residual

ownership of a corporation. These share have voting rights and cannot be called. Preferred

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 stock has preference over common stock with respects to dividends and to distributions in
the events of liquidation.

 When capital stock is issued, appropriate asset

accounts are debited for the market price of stock. A capital stock account is credited for
the par value of the issued shares. The difference between the market value received and
the par value of the issued shares is credited or debited to additional paid in capital
accounts.

 The stockholders; equity sections are classified into

two: paid-in-capital and retained earnings.

 Any treasury stock held at the end of an accounting

period is deducted from the total of the paid-in-capital and retained earnings of the
corporation.

 To determine the equity per share, the equity

allocated to each class is divided by the number of shares outstanding of the respective
class.

preferences as to dividends and in the distribution of assets inevents of liquid action.

Stock certificate: a document issued by a corporation as evidence of the ownership of the

number of shares stated on the certificate.

Subscriptions to Capital stock: formal promises to buy shares of stock from a corporation
with payment at a later date.

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