What is a Partnership? 

A partnership is a kind of arrangement between two or more people whereby they agree to manage the business operations and share its profits and losses in an agreed ratio between them. The agreement that is drafted and signed by the partners of the firm is termed as partnership deed and contains various important clauses agreed between the partners such as profit/loss sharing, interest on capital, remuneration allocation of each partner, drawings, admission of a new partner, etc. 

What is Partnership Accounting? 

Partnership accounting refers to a process where each partner to the firm reports his/her share of the partnership profits, losses, remuneration, deductions, etc. for tax purposes on his/her return. The partnership is usually required to file a tax return but is not subjected to tax. 

Accounting Treatment for Partnership 

1. Accounting for initial investments. 

Under the partnership firm, the ownership rights are usually divided among two or more partners, so for that very purpose, each partner is required to maintain separate drawings and capital accounts. 

Where a cash investment is made by the partner in a partnership, the cash account is debited, and the capital account of the partner is credited for the same amount that is invested. 

In the case where an investment other than cash is made by the partner, the asset account is usually debited and the capital account of the partner is credited with the market value of the asset. 

 2. Accounting for capital and capital interest 

The capital account of each partner represents the amount of capital invested by him/her in the partnership firm. The capital account of a partner usually gets increased when the additional investments are made by the partner during the year or guaranteed payment is made towards the firm by him/her. In cases where the partnership earns profits, the same is allocated to the partners in a certain ratio which increases their capital account. The capital account of a partner is usually decreased when cash is withdrawn by the partners. 

The capital interest is generally an interest that a partner receives owing to its own on the shares in the partnership, in case of liquidation of the partnership firm. 

3. Allocation of net income. 

 In the case of a partnership, if the total revenue exceeds the total expenses incurred during the period, the resultant is the net income of the partnership and vice versa is the net loss. The allocation of income generated or loss incurred is done amongst the partners following the terms of the agreement, however, if there is no such agreement, the profit and loss are shared equally amongst the partners regardless of the initial investment made by them. 

Goodwill in Partnership Accounting 

Goodwill is generally the reputation which the partnership firm has gained over the years and it is this reputation that generally translates into monetary terms and gives expected future profits. The items which are included in goodwill include intellectual property, brand recognition, etc. 

The goodwill is generally calculated by taking the purchase price of the company and subtracting the difference between the fair market value of the assets and liabilities. The goodwill is generally recorded as an intangible asset on the balance of the company which acquires it because it is not a physical asset like land or buildings. As per the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) it is mandatory for the companies to evaluate the value of goodwill at least once a year and record the same in their financial statements and also record any impairments. 

Goodwill Impairments 

The impairment of an asset usually occurs when the market value of the asset becomes lower than the historical cost (which is the original purchase price of the asset). The impairment is normally the result of a competitive environment or economic depression. 

Methods of Performing Impairment Test on Goodwill 

• Income Approach 
• Market Approach 

Under the income approach the estimated future cash flows are discounted to their present value while in the case of the market approach, the companies which work in similar industries are analyzed based on their assets and liabilities column in the balance sheet. The impairment generally results in decreasing the goodwill balance on the balance sheet and the expenses so incurred have a direct impact on reducing the net income for the year. 

Types of Goodwill 

Two types of goodwill exist under US accounting 

1. Institutional goodwill (Enterprise):  It may be described as the intangible value that would continue to occur and increase the value of the value, even in the absence of its owner. 

2. Professional goodwill (Personal): It is generally the kind of goodwill whose increase in value may be solely attributed to the efforts of the business owner or his reputation. 

Admission of a Partner 

In Partnership Accounting admission of a partner is one of the important events that take place. It means the inclusion of a new person in the existing partnership firm and to claim the rights of sharing profits/losses in the firm, the incoming partner is required to bring in some amount which is generally referred to as his share of goodwill or he may also bring the capital share to be contributed by him. 

Withdrawal of a Partner 

The withdrawal of a partner from the partnership firm can be done by giving notice to remaining partners of the firm in advance stating the explanation withdrawing. The partnership agreement commonly mentions the time frame within which the notice period is required to be served. There are two kinds of withdrawal. 

• Voluntary Withdrawal: It takes place when a partner chooses to discontinue the partnership and serve a notice for the same on the other existing partners in the firm. The voluntary withdrawal usually happens in the case of the retirement of a partner. 
• Involuntary Withdrawal: It is a kind of withdrawal wherein the partner is disassociated from the existing partnership firm without his consent and all other existing partners jointly serve a notice for his withdrawal. The partnership agreement so drafted mentions the condition under which a partner may be involuntarily discontinued from the firm. This kind of withdrawal usually happens in case of death of a partner, incompetence, incapacity of a partner to carry on in the firm or owing to his/her criminal conviction. 

Remuneration of a Partner 

Partnership accounting involves the remuneration and profit-sharing of each partner. The partnership agreement generally states how the net income or loss will be allocated to the partners. In cases where the agreement is silent, the net income or loss is generally allocated in an equal ratio to all partners. 

The partners usually do not receive a salary but the partnership agreement gives each partner the right to withdraw assets equivalent to his/her capital balance. However, there are certain partnership agreements where salary and interest on investments for partners are mentioned. 

The partnership generally accrual basis of accounting where they pay federal income taxes on their net income share irrespective of how much cash they have withdrawn from the partnership during the year. After allocation of net income, it is transferred to the individual partners' capital accounts through closing entries. 

For example, ABC Consultant, a partnership firm earned $90,000 and the agreement read that all profits are to be shared equally amongst partners X, Y, and Z. Therefore, each of the three partners would be allocated $30,000 ($90,000 ÷ 3). The allocation of income will be recorded by passing the following journal entry. 

Partnership Accounting Date 

The partnership accounting date is normally the accounting period in which the business prepares its accounts. The normal accounting period is of 12 months provided there is no change in the accounting date.  

Tax Filing and Accounting in Partnership 

In the case of a partnership, the profits and losses are allocated to the partners in an agreed ratio and as such, they are required to pay taxes on the profits so earned. The partnership itself has no liability to pay taxes, but it is, however, liable to file Form 1065 with the Internal Revenue Service. 

The partners however have the liability to file their income tax return on Form 1040 Schedule E. The partnership accountant is obligated to send an IRS Schedule K-1 to each partner for reporting the amount of money allocated to that partner from the business and that must be sent at the end of the accounting period. 

Formulas 

Calculation of net income: (Total Revenue - Total expenses incurred during the accounting period). 

Calculation of Goodwill: P- (A-L)   

where, 

• P = Purchase price / Historical cost of the target company.
• A = Fair market value of the assets.
• L = Fair market value of the liabilities.

Common Mistakes and Pitfalls 

The care must be taken while doing partnership accounting that the capital must be allocated properly and profit-sharing has to be following the ratio so agreed between the partners in the agreement. 

The valuation of goodwill at the entry of the new partner has to be taken care of. In the case where the partner withdraws from the firm or dies, the assets are to be revalued. 

Context and Applications 

This topic is important in the professional exams for: 

• B.com (Honors) (Bachelor of Commerce) 
• M.com (Master of Commerce) 
• Chartered Accountants (CA) 
• Company Secretary (CS) 
• MBA (Master in Business Administration) (Finance)