Partnership accounting
/How to Account for a Partnership
The accounting for a partnership is essentially the same as is used for a sole proprietorship, except that there are more owners. In essence, a separate account tracks each partner's investment, distributions, and share of gains and losses.
Overview of the Partnership Structure
A partnership is a type of business organizational structure where the owners have unlimited personal liability for the business. The owners share in the profits (and losses) generated by the business. There may also be limited partners in the business who do not engage in day-to-day decision making, and whose losses are limited to the amount of their investments in it; in this case, a general partner runs the business on a day-to-day basis.
Partnerships are a common form of organizational structure in businesses that are oriented toward personal services, such as law firms, auditors, and landscaping.
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Accounting for a Partnership
There are several distinct transactions associated with a partnership that are not found in other types of business organization. These transactions are noted below.
Contribution of Funds
When a partner invests funds in a partnership, the transaction involves a debit to the cash account and a credit to a separate capital account. A capital account records the balance of the investments from and distributions to a partner. To avoid the commingling of information, it is customary to have a separate capital account for each partner.
Contribution of Other than Funds
When a partner invests some other asset in a partnership, the transaction involves a debit to whatever asset account most closely reflects the nature of the contribution, and a credit to the partner's capital account. The valuation assigned to this transaction is the market value of the contributed asset. Market value is derived as of the day on which the contribution occurred.
Distribution of Funds
Distributions to partners may be extracted directly from their capital accounts, or they may first be recorded in a drawing account, which is a temporary account whose balance is later shifted into the capital account. The net effect is the same, whether a drawing account is used or not.
Withdrawal of Funds
When a partner extracts funds from a business, it involves a credit to the cash account and a debit to the partner's capital account. This may require the approval of the other partners, depending on the terms in the partnership agreement.
Withdrawal of Assets
When a partner extracts assets other than cash from a business, it involves a credit to the account in which the asset was recorded, and a debit to the partner's capital account.
Allocation of Profit or Loss
When a partnership closes its books for an accounting period, the net profit or loss for the period is summarized in a temporary equity account called the income summary account. This profit or loss is then allocated to the capital accounts of each partner based on their proportional ownership interests in the business. For example, if there is a profit in the income summary account, then the allocation is a debit to the income summary account and a credit to each capital account. Conversely, if there is a loss in the income summary account, then the allocation is a credit to the income summary account and a debit to each capital account.
Tax Reporting
In the United States, a partnership must issue a Schedule K-1 to each of its partners at the end of its tax year. This schedule contains the amount of profit or loss allocated to each partner, and which the partners use in their reporting of personal income earned.
Partnership Recordkeeping
A partnership is supposed to maintain its own accounting records. This is called the business entity concept, which states that the transactions associated with a business must be separately recorded from those of its owners or other businesses. Doing so requires the use of separate accounting records for the partnership that completely exclude the assets and liabilities of the partners. Otherwise, the records of multiple entities would be intermingled, making it quite difficult to discern the financial results of the partnership. A clean split between the records of the partners and a partnership allows the following to occur:
The calculation of profits and losses, which can then be allocated to the partners’ capital accounts.
The amounts of payouts that can be issued to the partners in the event of a liquidation of the partnership.
A set of financial records that can be successfully audited.
An appropriately detailed level of recordkeeping requires the accountant to maintain a separate chart of accounts for the partnership and a general ledger in which all transactions are recorded, and to periodically issue a complete set of financial statements that reveal the financial results, position, and cash flows of the partnership.