Chapter 19 Partnerships. Copyright © Houghton Mifflin Company. All rights reserved.19 | 2 General Partnership (GP) An association of two or more people

Chapter 19

Partnerships

Copyright © Houghton Mifflin Company. All rights reserved. 19 | 2

General Partnership (GP)

• An association of two or more people or firms to carry on, as co-owners, a business for profit

A voluntary association entered into by the partners


General Partners

• General partners actively and publicly participate in the transactions of the firm and have unlimited liability.

• Each party owns a fractional share of all the assets.


Unlimited Liability

• Each partner is personally liable to creditors for all the debts the partnership incurs during his or her membership in the firm.

• New partners may or may not assume liability for prior partnership debts.

• Partners who withdraw from a firm must give adequate public notice of withdrawal.

– If he or she does not, he or she may be held liable for debts the partnership incurs after his or her withdrawal.


Limited Partnership (LP)

• An organization with two or more people or firms with at least one general partner and one limited partner

General PartnersMay have little or no

investment, organizes, manages, and controls

operations

Limited PartnersHave largest share of invested capital, not

involved in day-to-day operations, and usually cannot lose more than

their capital contribution


Limited Liability Partnership (LLP)

• An organization similar to a limited partnership except that all partners may take an active role in the business with only their invested capital at risk

© Royalty Free PhotoDisc/ Getty Images


Limited Life

• Partnerships have a limited life.• Partnerships end as a result of:

– The death or withdrawal of a partner– Bankruptcy– Expiration of the period of time

specified in the partnership agreement– Completion of the project for which the

partnership was formed


Mutual Agency

• Mutual agency is the ability of each partner to act as an agent of the firm, thereby committing the entire firm to a binding contract.

• Each partner can enter into binding contracts in the name of the firm for the purchase or sale of goods or services within the normal scope of the firm’s business.


Mutual Agency

• If the partners agree among themselves to limit the right of any partner to enter into certain contracts in the name of the firm:– This agreement is not binding on outsiders who

are unaware of its existence.– If the partners want the limitation to become

effective, they should notify their existing and potential customers.


Advantages of a Partnership

1. Opportunity to pool abilities and capital of people or firms

2. Easy to create (requires only a partnership agreement—written or oral)

3. Minimal legal restrictions (partnership must have a legal purpose)

4. No federal income taxes levied against a partnership as an entity, but the partnership must file an information form with the IRS (Form 1065)

– The partners will report their distributed share of income on their individual return (whether or not this share is taken out of the business).


Disadvantages of a Partnership

1. Unlimited liability– General partners (who actively and publicly

participate in transactions of the firm) are personally liable for all the partnership debts.

2. Limited life– Could also be an advantage

3. Mutual agency– Actions of one partner are binding on the other

partners.– Could also be an advantage


Disadvantages of a Partnership (cont’d)

4. Difficulty of transferring a partial or entire partnership interest to another person

– Such a transfer must be agreed to by all partners.

5. Difficulty of managing relationships with partners


Partnership Agreements

• Written contracts preferred over oral contracts• Provisions usually included in written partnership

agreements:– Effective date of the agreement– Names and addresses of the partners– Name, location, and nature of the business– Management structure– Duration of the agreement– Investment of each partner– Procedure for sharing profits and losses– Withdrawals to be allowed each partner– Procedure for a partner’s exit from the business– Provisions for division of assets upon liquidation


Partnership Accounting

• The only difference between accounting for a sole proprietorship and a partnership is the owners’ equity accounts:

– Capital account for each partner– Drawing account for each partner


Recording Investments

• Record separate journal entries for the investment of each partner.

– When a partner’s contributed assets are greater than the partner’s assumed liabilities, credit the partner’s Capital account.

Investments of partners may include cash and other assets, along with

related liabilities.


Recording Initial Investments:An Example

• On February 2, Rita and Ralph agree to form a partnership to operate a jewelry store.

• Rita invests cash.


Recording Initial Investments:An Example (cont’d)

• Ralph contributes the existing assets and liabilities from a prior business:

Cash $ 2,900 Accounts Receivable 18,000Allowance for Doubtful Accounts 200 Merchandise Inventory 180,400 Equipment 16,000 Accumulated Depreciation, Equipment 4,500 Notes Payable 1,600 Accounts Payable 8,400


Recording Contributed Assets and Liabilities

1. Determination of the value of the noncash assets (inventory, equipment) required

2. May require revaluation by an independent appraiser

3. New aging of accounts receivable required


Recording RevaluedAssets and Liabilities


Additional Investments by the Partners

• Each partner invests an additional $7,000.


Partners’ Capital Accounts


Partners’ Withdrawals

• Withdrawal of $4,620 by Ralph H. Fox, $3,742 by Rita L. Lang.


Distributive Share

• A distributive share is the share of the net income (or net loss) allocated to each partner.

• The allocation of net income or loss may be reported as a separate statement or shown at the bottom of the income statement below net income.


Methods for Dividing NetIncome/Loss Between Partners

1. Fractional shares2. Ratio of capital investments3. Salary allowances4. Interest allowances

• If the partnership agreement fails to state a specific method of division, from a legal standpoint, the partners should share any net income or loss equally.


Division of Net Income/Loss for a Partnership: Two Examples

• A net income of $248,000

• A net loss of $4,000

© Royalty Free PhotoDisc Blue/ Getty Images


Balances in the Capital and Drawing Accounts

Using this example, we will look at each of the four methods of division of net income or loss.


Fractional Shares Method

• The agreement states that the two partners will divide the net income or loss in fractional shares of ¾ and ¼.

© Royalty Free PhotoDisc Blue/ Getty Images


Calculating Fractional Shares

• Multiply net income or loss by each partner’s fraction as stated in the agreement.– For ratio listings, convert ratios to fractional shares as

shown in the example below.


Division of Net Income of $248,000


T Accounts with Steps 3 and 4 Labeled


Division of Net Loss of $4,000


Ratio of Capital Investments Method

• Multiply net income or loss by a fraction with the partner’s beginning Capital balance in the numerator and the total of partners’ Capital balances in the denominator.

• This method is appropriate for businesses whose earnings are closely related to the amount of money invested:– Real estate ventures– Cattle feeding operations


Calculating the Ratioof Capital Investment

Bell $300,000 Campbell 75,000Total $375,000

Bell’s share $300,000 / $375,000 = .80 Campbell’s share $75,000 / $375,000 = .20

Bell’s share of earnings $248,000 × .80 = $198,400 Campbell’s share of earnings $248,000 × .20 = $49,600



Bell’s share of the loss $4,000 × .80 = $3,200 Campbell’s share of the loss $4,000 × .20 = $800


Salary Allowances

• Allocations of net income– A means of recognizing and rewarding differences in

ability and in the amount of time devoted to the business

– Guaranteed amounts determined without regard to the income of the partnership

• Not payments to partners– Withdrawals are recorded in Drawing accounts


Salary Allowances (cont’d)

• Not payments to employees– Payments to employees are recorded as Wages or

Salaries Expenses

• Included in the division of net income/loss section of the income statement


Salary Allowance Method

• Deduct the amounts of salary allowances from the net income (or add them to the net loss) and divide the remainder by specified shares (usually equally).

• Assume the two yearly salary allowances are:– $60,000– $40,000



Net income $248,000Less allocated as salaries ($60,000 + $40,000) 100,000Remainder $148,000

Remainder / 2 = $148,000 / 2 = $74,000


Division of Net Incomeon the Income Statement



Net loss $ (4,000)Less salary allowances ($60,000 + $40,000) 100,000Remainder $(104,000)

Remainder / 2 = $(104,000 / 2 = $(52,000)


Division of Loss onthe Income Statement


Interest Allowances

• Allocations of net income– Guaranteed amounts determined without regard to

the income of the partnership– Act as an incentive to make capital investments

• Not interest expense


Calculating the Interest Allowance

1. Multiply allotted interest rate by partner’s capital investment.

2. Deduct the amounts of interest allowances from the net income (or add them to the net loss) and divide the remainder by specified shares (usually equally).

• For our continuing example, let’s assume the interest rate is 6 percent.


Division of Net Income Based on Interest Allowances

Interest allowance for Bell: Capital Balance × Interest Rate $300,000 × .06 = $18,000

Interest allowance for Campbell: Capital Balance × Interest Rate $75,000 × .06 = $4,500


Division of Net Income Based on Interest Allowances (cont’d)

Net income $248,000Less: Salary allowance $60,000 + $40,000 $100,000 Interest allowances $18,000 + $4,500 22,500 122,500 Remainder $125,500

Remainder / 2 = $125,500 / 2 = $62,750






Division of Loss Based on Interest Allowances

Net loss $( 4,000)Less: Salary allowances $60,000 + $40,000 $(100,000) Interest allowances $18,000 + $4,500 (22,500) (122,500) Remainder $(126,500)

Remainder / 2 = $(126,500) / 2 = $(63,250)


Entry to Close Net Income into Capital


Entry to Close the DrawingAccounts into the Capital Accounts


Closing Entries



Statement of Partners’ Equity

• Format is the same as that for a statement of owner’s equity.

• Use a Total column to record the combined total for each line.

• List additional investments (after beginning of period) directly below the beginning Capital balance.

• Use one column per partner to record each partner’s:

– Beginning capital– Additional investment– Share of net income– Withdrawals– Ending capital


Statement of Partners’ Equity:An Example


Dissolution

• Dissolution is the ending of a partnership because of a change in the personnel of the membership and the forming of a new partnership.

– One partnership ends and a new one begins.

• The transition results primarily in changes in the Capital accounts, with routine business being carried on as usual.

• Any change in the composition of partners results in a dissolution of the partnership.


Recording the Saleof a Partnership Interest

• Debit the Capital account of the old partner.

• Credit the Capital account of the new partner.

© Royalty Free C Squared Studios/ Getty Images


Sale of Partnership Interest

• If a retiring partner sells his or her interest (Capital balance of $163,520) for $182,000, the partner pockets the profit and the partnership records an entry as follows:


Withdrawal of a Partner

• The partnership agreement should outline the procedures for withdrawal, requiring:

– An audit of the books– A revaluation of the assets to reflect their market

value

• A loss or gain on revaluation is shared according to the ratio agreed upon in the partnership agreement.

• An example of a partner withdrawing the book value of his or her equity after revaluation follows.


Journal Entry to Reflect the Loss to Partners After Revaluation


Updated Capital Accounts


Recording the Journal Entryto Reflect Withdrawal of Partner


Partner Withdraws More ThanBook Value of His or Her Equity

• Sometimes a partner withdraws more cash than the amount of his or her Capital account.

• Possible reasons:– The business is prosperous and shows excellent

potential for growth.– The remaining partners may want to provide an

incentive for the partner to withdraw.


Partner Withdraws, Receiving More Than Book Value of His or Her Equity

• At the end of the given year, if the remaining partners paid $1,000 more than the book value of the withdrawing partner, the journal entry would look like this:


Partner Withdraws, Receiving Less Than Book Value of His or Her Equity

• At the end of the given year, if the remaining partners paid $4,200 less than the book value of the withdrawing partner, the journal entry would look like this:


Death of a Partner

• Death automatically ends the partnership.• Books must be closed to determine the net

income or loss.• The death of a partner usually calls for an audit

and a revaluation of the firm’s assets.• The partner’s estate is entitled to receive the

amount of his or her equity.• The remaining partners and the executor of the

estate determine the form of payment.


Definitions

• Liquidation– The ending of a partnership and the business itself

• Sale of the assets• Payment of the liabilities• Distribution of the remaining cash to the partners

– Remember: Creditors are paid before partners!

• Realization– Conversion into cash, as happens with the sale of

assets


New Account:Loss or Gain from Realization

• Used when there is a gain or loss from realization• Has DR and CR, but no “+” or “-”• Similar to:

– Cash Short and Over– Income Summary


Journalize Entries forEach Step of the Liquidation Process

1. For the sale of the assets:– Debit Cash.– Credit the assets.– Record the difference in Loss or Gain from

Realization.

2. Close Loss or Gain from Realization into the partners’ Capital accounts according to the partners’ agreed-on profit and loss ratio.

3. Pay off the liabilities.4. Distribute the remaining cash according to the

partners’ Capital account balances.


Simplified Example of Liquidation

• We will look at a partnership with three partners:– The fractional shares that the partners use for

division of net income or loss (and liquidation) are as follows:

• ½, ¼, ¼

• We will look at the balance sheet before the sale of assets and settlement of liabilities during the liquidation.

• Then we will look at the journal entries during liquidation and the resulting T accounts.


Balance Sheet Before the Sale of Assets


Journal Entries toRecord Sale of Assets


Journal Entries to Record Settlementof Liabilities and Distribution of Cash


Cash and CapitalAccounts After Liquidation


Journal Entries to Record Sale of Assets at a Loss


Entries to Record Settlement of Liabilities and Distribution of Cash


Cash and CapitalAccounts After Liquidation


Closing Entries


Closing Entries

Documents

Chapter 19 Partnerships. Copyright © Houghton Mifflin Company. All rights reserved.19 | 2 General Partnership (GP) An association of two or more people