Alright, we’re starting from the top. Let’s start with the good old definition.

By the contract of partnership, two or more persons bind themselves to contribute money, property or industry to a common fund with the intention of dividing profits among themselves.

3 Distinct Factors (from the definition)

Association of two or more persons

To carry on as co-owners

Conducted for profit

A partnership involves at least two persons. There was no limit as to maximum, but ideally, it shouldn’t exceed ten. This is mostly for convenience as partnership equity is recorded for each partner. One partner will be given his own Capital and Drawings account. That’s two accounts per partner. If you have too many partners, recording would be a complication – in recording, distributing profits, and in managing the business (in general).

The partners agree to become co-owners of whatever they contribute to the partnership. Contributions may be in the form of money (bills and coins), property (land, building, equipment, etc.) or industry (talent and skills). Later, we will discuss how these contributions are recorded and accounted for.

The partnership is created with the intention of doing business for profit. Let’s face it, no one conducts business to be at a loss. When we do business, we expect profit, a source of return for our investments (contributions).

These three are the essential factors describing a partnership.

Characteristics of a Partnership

Separate Legal Personality – the Partnership, using its own business name, is recognized as a separate entity, apart and different from the partners.

Ease of Formation – by mere agreement of at least two individuals, a partnership can be formed.

Co-ownership of Partnership Property and Profits – everything contributed to the partnership becomes partnership assets and are co-owned by the partners. If one partner contributed a building to the partnership, the building will no longer be on his name (as owner) but will be recognized as partnership asset and is co-owned by the contributing partner with the other partners.

Limited life – it’s easy to form a partnership, but it’s also easy to dissolve. When a partner withdraws from the partnership, that ends the partnership life. When a new partner joins the partnership, that also ends the partnership life and starts anew. More of this on the discussion on dissolution.

Mutual agency – every partner is allowed to represent the partnership. Basically, the partners can act as agents of the partnership, and enter into contracts under the Partnership (as long as it’s stated in the Partnership agreement).

Unlimited liability – this is mostly the deal-breaker. When you become a partner, you contribute assets. If the partnership becomes insolvent (liabilities are greater than assets), the creditors can go after the personal assets of the partners (if they are solvent).

Partnership Agreement

A partnership agreement must be done at the inception of the partnership. This agreement details how the partners will operate the business of the partnership. This includes the formation, operation, dissolution, and liquidation.

A detailed partnership agreement seeks to minimize or eliminate confusion and conflicts that may arise from the conduct of business.

A partnership is formed by mere agreement, which can be oral, implied, or written. But to be safe, and to keep records intact, it’s better to have a written contract or agreement.

The agreement can cover the following:

1. Name of the partnership and the nature of business, the names of the partners
2. Date the partnership agreement will take effect and the duration of the contract
3. Contributions to be made by each partner, treatment of the contribution, agreed valuation, agreement on the existence of mandatory contributions or additions and the corresponding penalties for those who couldn’t comply with the mandates
4. Authority, rights and duties of each partner
5. Accounting period to be used, keeping of accounting records, preparation and audit of financial statements
6. Method of sharing profit/loss to partners, including frequency of income measurement and distribution to partners
7. Disposition of drawings or salaries to each partner, interest rate for capital, and penalties for exceeding allowed withdrawals
8. Provision on how to arbitrate conflicts, rules on valuation of assets, liquidation procedure, and other provisions that may affect the partners and the partnership

This basically covers everything that needs to be addressed.

How do we value someone’s contribution? Do we record equal capital balances or based on actual contributions? How do we divide the profit? How do we divide the loss? How much can we withdraw during the year? Do we get salaries and interest? Who should be in charge? What would the rest of us do? How do we conduct business? Who’s the boss? Do we vote on major decisions? What happens when we withdraw from the partnership? How much will we get? And pretty much things like these.

Partner’s ledger accounts

For each partner, we setup a Capital account and a Withdrawal account.

If the partnership agreement provides for Loans to Partners and Loans from Partners, then we also set up these accounts when needed for each partner.

Capital account – we use this for the initial contribution and additional investments of a partner. It is also debited for the balance of the Withdrawal account at the end of each reporting period.

Withdrawal account – we use this for withdrawals made by the partner. The balance of this account is deducted from the capital account at the end of each reporting period.

This is a complication, some books would tell you that if it’s a permanent withdrawal (meaning the partner won’t return it as investment in the partnership), then you have to use the Capital account, instead of the Withdrawal account. If it’s a temporary withdrawal (meaning the partner will return it as investment in the partnership soon), then use the Withdrawal account. In real life application, it doesn’t really matter. It’s based on company policy, unless your company is a stickler for following that.

Loans to Partners – if the partnership agreement allows for partners to get a loan from the partnership (not a Withdrawal), we use this account. The partnership has a receivable from the partner/s, and the partner has a liability to pay the partnership.

Loans from Partners – if the partnership agreement allows for the partners to extend a loan to the partnership (not additional investment), we use this account. The partnership has a liability to pay the partner/s, and the partner has a receivable from the partnership.

Why not just use the Capital/Withdrawal accounts? Well, it could be that the partner expects to pay the partnership real soon, or the partner expects to get paid real soon, too. Or it could be that Loans from Partners are subject to interest, therefore giving the partner/s an additional income in the form of interest payments. Or there is a limit on Withdrawals and the penalty is higher than the interest rate charged on the Loans to Partners.

The loans accounts are set up for each partner, just like the capital and withdrawal accounts.

Say:

Loans to Partner – A

Loans from Partner – B

Still following? Cool.

Profits or losses, when distributed to the partners, are recorded on their Capital accounts.

How about salaries and interest on contributions? Well, that would depend on the agreed treatment (company policy). It could be recorded on the Capital account or Withdrawal account.

Let’s move on to the next section.

We’d love to continue with Partnership Formation, but it would be best to introduce the types of partnerships and partners first. :)