Accounting for Sole Proprietorships and Partnerships

 

 

 

A sole proprietorship is a business owned by one person.  Sole proprietorships are more numerous than any other form of business structure in the United States but typically they are smallest in size.  Accounting for sole proprietorships is very similar to corporate accounting; the differences being in the equity account area.

 

There are two equity accounts for a sole proprietorship, a capital account and a withdrawal account.  Since a proprietorship is not a corporation there are no capital stock, retained earnings, or dividend accounts.  Owner's investment is credited to a capital account.  Similar to corporations, revenue and expense are closed out to an income summary account.  Income summary, however, is closed out to capital.  The withdrawal account is also closed out to capital.  Note that owner investment and the effects of net income and withdrawals are all contained in the capital account.

 

For example, if Jane Smith invests $100,000 in a sole proprietorship, the entry to record the investment would be:

            Cash                                                    100,000

                        Jane Smith, Capital                                           100,000

 

After revenue and expense accounts are closed to income summary, final closing entries assuming net income of $20,000 and withdrawals of $12,000 would appear as follows:

            Income Summary                                  20,000

                        Jane Smith Capital                                            20,000

            Jane Smith, Capital                               12,000

                        Jane Smith, Withdrawals                                   12,000

 

A partnership is an association of two or more persons who co-own a business.  Accounting for partnerships is similar to accounting for a sole proprietorship except that each partner has a capital and a withdrawal account. 

 

Accounting for initial investment of partners is similar to that for sole proprietorships.  Any non-cash assets contributed by partners are recorded in the partnership records at fair market value not historical cost.   

 

Distribution of partnership profits and losses can be accomplished a number of ways and the distribution is invariably spelled out in a partnership agreement.  Some common methods include distribution based on stated ratios; based on capital balance ratios; based on "salary", interest, and stated ratios; etc.  Partnership drawings are recorded similar to those of a sole proprietorship.

 

 

 

 

There are two ways in which a new partner can be admitted to a partnership:

1.                  Purchase original partner's interest

2.                  Invest assets into the partnership

 

Regardless of the amount paid an original partner, the entry to record admission to the partnership by purchasing an original partner's interest would be:       

            Original Partner's Capital

                        New Partner's Capital

The amount debited and credited would be the original partner's capital balance.

 

To record admission when the new partner invests assets in a partnership, both the assets of the partnership and partners' capital accounts increase.  Depending on the amount invested by the new partner, there may be a bonus to the old partners or to the new partner.  I find it helpful in analyzing admissions to a partnership to use the accounting equation before and after admission.  Especially when there is a bonus involved, the accounting equation can be helpful to determining the impact on respective partners' capital accounts.

 

There are several ways in which a partner may withdraw from a partnership.  At withdrawal, an appraisal should be made of the assets to restate them at market value and adjust the capital accounts accordingly. 

 

If the withdrawing partner simply sells his/her interest to one of the remaining partners the entry is as follows:

            Withdrawing Partner, Capital

                        Purchasing Partner, Capital

Similar to an admission, the amount debited and credited is the balance in the withdrawing partner's capital account regardless of how much was paid by the purchaser.

 

In the event the withdrawing partner withdraws assets from the partnership itself a bonus either to the remaining partners or to the withdrawing partner may be involved.

 

Liquidation of a partnership is the act of going out of business and consists of the following steps:

1.  Sell all assets.  Allocate gain or loss to partners based on their profit/loss ratio.

            2.  Pay off all liabilities.

            3.  Disburse remaining cash, if any to partners based on their capital balances.