Basics of partnership accounting (Part II)

3. Dissolving a partnership - Capital deficits

The dissolution process becomes more complicated when one or more of the partners has a negative capital balance after liquidating all assets. Let’s recreate the final balance sheet from before; this time around, the partnership has not performed well and now owes a lot more to creditors by the time the partners are ready to call it quits.

JTB Final Balance Sheet

Assets

 

     Cash

$40,000

 

     Accounts Receivable

$25,000

 

     Office Equipment and Furnishings (net of depreciation)*

$40,000

 

     Building (net of depreciation)

$300,000

 
     

Total Assets

$405,000

 
     

Total Liabilities*

 

$305,000

     

Equity

   

     Partner Capital – Jerry

 

$60,000

     Partner Capital – Tom

 

$35,000

     Partner Capital – Bill

 

$5,000

(*) Multiple accounts combined for simplicity

Assume the same facts as before -- the partnership collects the full amount of receivables but can only sell the office equipment and furnishings for $30,000 and the building for $270,000. The same three accounting entries found in the section about partnership dissolution with capital deficits apply to this situation.

After asset liquidation the partner capital accounts will have the following balances:

  • Jerry’s capital balance is $40,000 = $60,000 - $5,000 - $15,000.
  • Tom’s capital balance is $23,000 = $35,000 - $3,000 - $9,000.
  • Bill’s capital balance is $(3,000) = $5,000 - $2,000 - $6,000.

Notice that Bill’s capital balance is now $(3,000) or negative. This means that he owes the partnership $3,000 and can be legally sued by the other partners for that amount. If he can satisfy the obligation, Jerry and Tom’s capital accounts stay the same. The partnership pays off its liabilities, Jerry receives $40,000, Tom receives $23,000, and Bill has to pay $3,000 to the partnership to compensate Jerry and Tom for his negative balance.

On the other hand, if Bill declares bankruptcy or the other partners choose not to file a claim against him, Jerry and Tom will treat the $3,000 as a loss. This time, we need to adjust the ownership percentages as if Billy were not a partner. To do so, we remove his ownership percentage from the denominator as follows:

Jerry’s Adjusted Ownership Percentage = 50%/80% = 62.5%

     Jerry’s Loss = 62.5% x $3,000 = $1,875

Tom’s Adjusted Ownership Percentage = 30%/80% = 37.5%

     Tom’s Loss = 37.5% x $3,000 = $1,125

The partnership pays off its liabilities, Jerry receives $38,125, Tom receives $21,875, and Bill receives nothing.

4. Partnership accounting recap

We have now covered the basics of starting a partnership, allocating income, and dissolving a partnership. There are many advanced facets of partnership accounting that are beyond the scope of this series. These include how to account for the withdrawal of a partner from the partnership, how to handle the sale of a partnership interest, admission of a new partner, and partnership tax topics among other areas of partnership accounting.

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