CHAPTER Partnerships: Characteristics, Formation, and Accounting for Activities Fundamentals of Advanced Accounting 1 st Edition Fischer, Taylor, and Cheng

CHAPTER

Partnerships:Characteristics, Formation,

and Accounting for Activities

Fundamentals of Advanced Accounting 1st Edition

Fischer, Taylor, and Cheng

88

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #2

Characteristics of a Partnership

• Association of two or more people as co-owners of a business

• Often governed by the Uniform Partnership Act (UPA)

• Voluntary association of individuals• Partners have fiduciary relationship• Mutual agency – Each partner is an agent

for other partners and the partnership


Legal Liability of Partnerships

• General partnership– Partners are general partners– All partners personally liable for all obligations of the

partnership

• Limited partnership– One or more general partners

• Personally liable for obligations of the partnership

– One or more limited partners• Maximum risk of loss is capital in the partnership• Do not participate in management of the firm


Legal Liability of Partnerships - continued

• Limited Liability Company (LLC)– Hybrid of corporation and partnership– Shareholders do not have personal liability for actions

by the entity– Not protected from their own wrongdoings

• Limited Liability Partnership (LLP)– All partners participate in management– Partners have limited liability caused by wrongdoings

of other partners– Partners are personally liable based on their own

actions or actions of those supervised


Equity Theories

• Proprietary Theory – Entity is viewed as the individual owners– Salaries to partners are distributions of income (not

expenses)– Unlimited liability extends to personal assets of owners– Partnership is not a taxable entity – income is passed

through and taxed to the individual partners– Original partnership is dissolved with admission or

withdrawal of a partner

• Entity Theory – business unit separate & distinct– Partnership enters contracts in it’s own name– Partners give up title to their contributions


Formation and Agreements

• Partnerships can be formed just by actions• The partnership agreement captures the

intent of the partners for major issues– Admission of partners– Withdrawal of partners– Allocation of profits and losses

• Uniform Partnership Act (UPA) covers some topics in the partnership agreement– Mostly used when there is no formal agreement or

if the agreement is silent on an issue


Acceptable Accounting Principles

• Partnerships may use GAAP– Not required if it adversely affects fairness of

financial statements

• There are other comprehensive basis of accounting (OCBOA) principles applicable– Cash basis accounting– Tax basis accounting


Accounts Used for a Partner’s Capital Investment

• Drawing account– A temporary account– Periodically closed to capital accounts– Represent assets withdrawn by partner from

partnership

• Capital account– A permanent account– Represents partner’s interest in the net assets

of the partnership (book value)


The Drawing Account Illustrated

Debit

Periodic withdrawals of partnership assets

Credit

Closing of balance to partner’s capital account

Drawing Account


The Capital Account Illustrated

Debit

Withdrawals in excess of a specified amount

Closing of a net debit balance in the partner’s drawing account

Partner’s share of partnership losses

Credit

Initial and subsequent investments of capital

Partner’s share of partnership profits

Capital Account


Partner’s Interest

• A partner’s interest in the net assets (book value) of the firm is different from their interest in profits and losses

• Partner may have a loan account– Partner borrows from the partnership– Partnership borrow from the partner


Initial Capital Investment

• Assets contributed by the partners are recorded at the agreed upon fair value

Example– Partner A contributes cash– Partner B contributes inventory & office equipment– Partnership assumes debt on the equipment– Equipment has $6,000 book value and $4,000 fair

value


Initial Capital Investment – Journal Entry

Cash 10,000Inventory 5,000Office equipment 4,000

Note payable 2,000Partner A, Capital 10,000Partner B, Capital 7,000

Note: Office equipment is recorded at fair value B’s capital account is reduce by loan assumed by

the partnership


Review – Partnership entries

Partner A loans partnership cash DR CashCR Partner A, Capital

Personal debt of partner B paid by partnershipDR Partner B, DrawingCR Cash

Partner B withdraws cash from partnershipDR Partner B, DrawingCR Cash

Net income is divided between partners A & BDR Income SummaryCR Partner A, CapitalCR Partner B, Capital


Division of Profits

• Should be identified in partnership agreement– If not, UPA says divide it evenly

• Several methods for allocating profit/loss– According to a ratio/percentage – According to capital investments of the partners– According to the labor/service rendered by

partners• Typically involving a salary and/or bonus


Profit and Loss ratios

• Partners are allocated % of profits/losses.

Example:

$20,000 profit

Partner A receives 60% x $20,000

Partner B receives 40% x $20,000

Total Partner A Partner B

Total Profit $20,000

Allocate 60/40 $12,000 $8,000


Capital Investment of Partners

Division of profits based on imputing interest on invested capital at a specified rate

Example• Partnership profit is $20,000• Interest on capital balances, 10% (before withdrawals)• Remaining profit allocated equally• Partner accounts are as follows:

10/1 30,000 1/1 100,000 4/1 10,000 1/1 60,0007/1 10,000

Partner A, Capital Partner B, Capital


Capital Investment of Partners (continued)

Partner A Partner B TotalInterest on beginning capital: A: 10% x $100,000 $10,000 $10,000 B: 10% x $60,000 $6,000 6,000

$16,000Balance per ratio (equally) 2,000 2,000 4,000

$12,000 $8,000 $20,000

•Interest is computed on beginning capital balances•Other alternatives:

•Ending capital balances•Average capital balances (weighted average)


Services Rendered by Partners

• Partner’s labor/service may be key to generating partnership revenue

• Allocate portion of income to partner as “salary”– Not an actual expense to partnership– Not considered drawing

• “Bonus” may recognize partner’s service– % of income before or after other criteria


Services Rendered by Partners - Example

ExampleNet Income = $120,000Allocation of salaries = $60,000Allocation of interest = $5,000Bonus = 10% of income after salaries and interest

Bonus = X% (Net income – Salaries – Interest)Bonus = 10% (120,000 – 60,000 – 5,000)Bonus = 10% (55,000)Bonus = $5,500


Multiple Bases of Allocation - Example

Example – ABC Partnership• Net Income = $33,000• Interest = 6% of ending capital balances over $100,000

– Partner A Ending Bal = $80,000– Partner B Ending Bal = $150,000– Partner C Ending Bal = $110,000

• Bonus = Partner C, 10% of NI after bonus• Salaries

– Partner A = $13,000– Partner B = $12,000

• Balance of income– 2:1:1 to A, B & C, respectively


Basic Schedule for Allocating ProfitsIllustration 8-2

A B C TotalInterest on capital - 3,000$ 600$ 3,600$ Bonus - - 3,000 3,000Salaries 13,000 - 12,000 25,000 Subtotal 13,000$ 3,000$ 15,600$ 31,600$ Remaining profit 700 350 350 1,400 Profit allocation 13,700$ 3,350$ 15,950$ 33,000$

Partner

Bonus is calculated as follows:Bonus = 10% (Net income – Bonus)Bonus = 10% (33,000 – Bonus)Bonus x 110% = $3,300Bonus = $3,000


Allocation of Profit Deficiencies and Losses:Two Alternatives

• Satisfy all provisions of the profit and loss agreement – Use the profit and loss ratios to absorb any

deficiency or additional loss caused by such action

• Satisfy each of the provisions to whatever extent is possible– For example, the allocation of salaries would be

satisfied to whatever extent possible before the allocation of interest is begun

– Ranked by order of priority


Deficiency Allocated By Order Of PriorityProfit allocation - Deficiency Allocated By P/L Ratio – Illustration 8-3

A B C TotalInterest on capital - 3,000$ 600$ 3,600$ Bonus - - 2,000 2,000Salaries 13,000 - 12,000 25,000 Subtotal 13,000$ 3,000$ 14,600$ 30,600$ Deficiency (4,300) (2,150) (2,150) (8,600) Loss allocation 8,700$ 850$ 12,450$ 22,000$

Partner



Deficiency Allocated By Order Of PriorityLoss Allocation - Deficiency Allocated By P/L Ratio – Illustration 8-4

A B C TotalInterest on capital - 3,000$ 600$ 3,600$ Bonus (not applicable)Salaries 13,000 - 12,000 25,000 Subtotal 13,000$ 3,000$ 12,600$ 28,600$ Deficiency (15,500) (7,750) (7,750) (31,000) Loss allocation (2,500)$ (4,750)$ 4,850$ (2,400)$

Partner

No bonus is calculated since it is based on a percentage of profit


Deficiency Allocated By Order Of PriorityProfit allocation - Deficiency Allocated

By Order of Priority – Illustration 8-5

A B C TotalInterest on capital - 3,000$ 600$ 3,600$ Bonus - - 2,000 2,000Salaries 8,528 - 7,872 16,400 Income allocation 8,528$ 3,000$ 10,472$ 22,000$

Partner



Special Allocation Procedures

• Partnership agreement may include special provisions for items that represent– Correction of prior year’s income– Current period non-operating gains/losses

• May be more equitable to base allocation on prior ratios

Documents

CHAPTER Partnerships: Characteristics, Formation, and Accounting for Activities Fundamentals of Advanced Accounting 1 st Edition Fischer, Taylor, and Cheng