The retirement of a partner dissolves an existing partnership and requires the adjustment of asset values to calculate the fair value of the equity of the partner retiring.
When the net assets are adjusted to fair value any gain or loss is allocated to all partners based on the current profit sharing arrangements and their capital accounts are debited or credited accordingly.
After this adjustment the balance on the retiring partners capital account represents the amount due to them based on fair value; however, this may of may not necessarily be the amount paid to the retiring partner.
Retirement of a Partner Example
Suppose a partnership has three partners A, B, and C. The partners share income in the ratio 35%, 45%, and 25% and after adjustment to fair value, have capital accounts of 115,000, 60,000, and 75,000 as summarized in the table below. Partner C has decided to retire.
| Partner | Share % | Capital |
|---|---|---|
| A | 30% | 115,000 |
| B | 45% | 60,000 |
| C | 25% | 75,000 |
| Total | 100% | 250,000 |
Payment is the same as the Capital Account Balance
The partners agree that on retirement partner C should be paid the amount shown on his adjusted capital account (75,000).
The bookkeeping entry to record the retirement of the partner is as follows.
| Account | Debit | Credit |
|---|---|---|
| C Capital Account | 75,000 | |
| Cash | 75,000 | |
| Total | 75,000 | 75,000 |
The balance on the partners capital account is cleared by the cash payment. The assets of the partnership are now reduced by the same amount.
Payment is Greater than the Capital Account Balance
In this second example the partners decide that the amount to be paid to the retiring partner is 90,000, a sum which is 15,000 greater than the amount on the retiring partners adjusted capital account of 75,000.
The difference between the amount paid and the adjusted capital account balance is normally accounted for using one of two methods.
- Bonus method
- Goodwill Method
The Bonus Method
Using the bonus method the excess payment is treated as a bonus to the retiring partner. The remaining partners incur the cost of paying the bonus in proportion to their relative profit sharing ratio before the partner retired.
In this example the retiring partner is paid 90,000 compared to the capital account balance of 75,000 and the bonus is therefore 15,000.
The remaining partners must incur the cost of this bonus in proportion to there relative profit share percentage before the partner retires. The bonus allocation is therefore calculated as follows.
Partner A bonus share = 30%/(30% + 45%) x 15,000 = 6,000 Partner B bonus share = 45%/(30% + 45%) x 15,000 = 9,000
Bonus Journal Entry
Using the bonus method the retirement of a partner for an amount in excess of fair value results in the following journal entry.
| Account | Debit | Credit |
|---|---|---|
| A Capital | 6,000 | |
| B Capital | 9,000 | |
| C Capital | 75,000 | |
| Cash | 90,000 | |
| Total | 90,000 | 90,000 |
The retiring partner is paid 90,000 in cash and their capital account of 75,000 is cleared. The cost of the bonus paid to the retiring partner (15,000) is allocated between the remaining partners.
Goodwill Method
Using this method goodwill is recognized and is recorded either for all partners or alternatively for only the retiring partner.
In the example above the goodwill associated with the retiring partner is the difference between the amount paid (90,000) and the value of their share of net assets (75,000) and therefore amounts to 15,000; the same as the bonus payment.
Since the retiring partner had a profit share of 25% the total goodwill relating to all partners can be calculated as follows.
Retiring partner goodwill = 15,000 Retiring partner share = 25% Goodwill relating to all partners = 15,000 / 25% = 60,000
The goodwill allocation between the partners is calculated as follows.
Partner A goodwill share = 30% x 60,000 = 18,000 Partner B goodwill share = 45% x 60,000 = 27,000 Partner C goodwill share = 25% x 60,000 = 15,000
The payment to the retiring partner can now be recorded in one of two ways.
Goodwill Recorded for all Partners
If the partnership decides to record the total goodwill of 60,000 then the following journal entry is posted to record the payment to the retiring partner.
| Account | Debit | Credit |
|---|---|---|
| Goodwill | 60,000 | |
| A Capital | 18,000 | |
| B Capital | 27,000 | |
| C Capital | 75,000 | |
| Cash | 90,000 | |
| Total | 135,000 | 135,000 |
The total goodwill of 60,000 is recorded in the accounting records of the partnership. The remaining partners A and B are allocated their share of the goodwill. The retiring partners capital account (75,000) is cleared and they are paid this amount plus their share of the goodwill (15,000) with cash of 90,000.
Goodwill Recorded only for the Retiring Partner
The alternative is that the goodwill is only recorded for the retiring partner. In this case the journal entry is as follows.
| Account | Debit | Credit |
|---|---|---|
| Goodwill | 15,000 | |
| C Capital | 75,000 | |
| Cash | 90,000 | |
| Total | 90,000 | 90,000 |
In this case the goodwill relating to the retiring partner of 15,000 is recorded, the capital account of 75,000 is cleared and the retiring partner is paid the amount of 90,000 in cash.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.