Chapter 13 - Lecture Notes

Chapter 13 –Accounting for Partnerships 1. Partnership – An association of two or more individuals acting as co-owners of a business for profit. 2. Basic Characteristics Flow through entity Voluntary association Based upon a contract. Can be written or oral. If there is a conflict as to the intent of the partners’, and there is no written agreement, the Uniform Partnership Act is used as the authoritative support. Mutual agency – Every partner can act as an agent of the partnership and bind the partnership to legal contracts without the knowledge and consent of the other partners. Therefore the acts of each partner will bind the entire partnership and becomes the obligations of all the partners. Unlimited Liability – Each partner is potentially liable for the financial interest of the partner and up to the extent of the partner’s personal assets. Creditors can go after the personal assets of the partners and the creditors can turn to the remaining partners to pay for the debts of the partnership. Therefore if the partnership becomes insolvent, the partners must contribute a sufficient amount of personal assets to settle the debts of the partnership. Income or loss is distributed to the partners in accordance with their profit and loss ratios. A partnership is a non-taxable entity and therefore there is no tax liability at the partnership level for purposes of federal income tax. The partnership must file federal form 1065, which is an information return. The distibutive share of the partnership’s net income or loss, flows through to the individual partners on a K-1 form (Partner’s Share of Income and Loss) Any tax liability is paid at the individual partner’s level on their Form 1040. Limited life – death, bankruptcy, or anything that takes the ability of the partners to contract, automatically ends the partnership. Co – ownership of partnership property. When a partnership is dissolved, the partner’s claims against the assets of the partnerships are measured by the balances that exist in each partners capital account. 3. The following must exist in a partnership: a) a capital account for each partner b) a withdrawal (or drawing) accounts for each partner. c) A measurement and a division of earnings.

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4. Since partners are not considered employees of the partnership, salary allowances are not deducted as expenses of the partnership. These are considered as a division of income and are credited to the partners’ capital account. This is one method to recognize the different abilities and time expended by each partner in the partnership. 5 Interest on the partners’ investments is not expenses of the partnership. 6 In the absence of a contrary agreement, the income or loss of a partnership is to be sheared equally amount the partners. 7 Methods of allocating partnership earnings to partners: a) stated percentages or fractions assigned b) the ratio of their capital investments c) salary and interest allowances and the reminder in a fixed ratio. 8

On the balance sheet, the owners’ equity (capital) section must show separate capital accounts for each partner.

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Statement of Changes in Owners Equity

Beginning capital balance Add: Additional investments by the owners Net Income/(Loss) Subtotal Less: Withdrawals by the partners Ending Capital balance

XXX XXX XXX XXX XXX XXX XXX ====

10 When a partner withdraws from the partnership, in theory the old partnership ceases to exist. 11 The business may continue to operate with the remaining partners, however it is really a new partnership. 12 Withdrawal of a partner from a partnership: a) a withdrawing partner may sell the interest to another person who pays for the interest by transferring cash or other assets to the withdrawing partner. b) cash or other assets are distributed to the withdrawing partner in settlement of his/her partnership interest. 13 Admission of a new partner to the partnership:

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a) a new partner may purchase an interest directly from one or more of the partners. Neither the total assets nor total owners equity of the partnership is affected. This is a transaction between individuals and not the partnership. b) A new partner may join an existing partnership by investing cash or other assets in the business. Both the total assets and total owners’ equity are increased. 14 Sale of a partnership interest Abbott, Burns, and Camp are partners. Camp sells his 5,000 interest in the partnership to Davis for 7,000. Entry to record Camp, Capital Davis, Capital

5,000 5,000

(to transfers Camp’s equity in the partnership to Davis) NOTE: a) The 7,000 that Davis paid to Camp is not recorded in the partnership’s books. This is a personal transaction between Camp and Davis. b) The only entry to record is the transfer of the recorded partnership interest of 5,000 from Camp to Davis. c) The amount is paid directly to Camp. The partnership is not a party to this transaction; the total assets and equity of the partnership are not affected by this transaction. d) Abbott and Burns cannot prevent Camp from selling his interest to Davis. e) However, Abbot and Burns must agree to the sale and transfer if Davis is to become a new partner. f) If Abbott and Burns accept Davis, then a new partnership is formed and a new contact is created with new income and loss ratios and other stipulations. g) If Abbott and Burns do not agree to accept Davis as a partner: (i)

Davis gets Camp’s share of the partnership interest and the partnership income and loss ratio.

(ii)

If the partnership is liquidated, Davis will get Camp’s share of the assets.

(iii)

Davis has no voice in the management of the business until he has been formally admitted and accepted as a partner.

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15 Investing assets by an incoming partner in the partnership The following are independent situations based upon the following fact pattern: A and B have a partnership with the balances in their capital accounts of 38,000 and 32,000 respectively. (a) C will pay 20,000 for a 1/3 interest in the assets of the partnership and share of the earnings. A’s capital 38,000 B’s capital 32,000 Original Equity 70,000 The profit and loss ratio was 50/50. After the investment of C A’s capital 38,000 B’s capital 32,000 C’s investment20,000 Adjusted Equity

90,000

C’s equity interest is 1/3 of 90,000 = 30,000. C invested 20,000 for a capital interest of 30,000. The difference of 10,000 is recorded as a bonus to the new partner. The bonus is allocated to the new partner from the old partners’ capital balances in accordance with their profit and loss ratios. Therefore the entry to record the bonus to the incoming partner would be as follows: Cash A, Capital B, Capital C, Capital

20,000 5,000 5,000 30,000

(b) Assume the same situation except that C will now receive a 20% interest in the partnership for his investment of 30,000. A’s capital 38,000 B’s capital 32,000 Original Equity 70,000 The profit and loss ratio was 50/50.

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After the investment of C A’s capital 38,000 B’s capital 32,000 C’s investment20,000 Adjusted Equity

90,000

C’s equity interest is 20% of 90,000 = 18,000 C invested 20,000 for a capital interest of 18,000. The difference of 2,000 is recorded as a bonus to the old partners. The bonus is allocated to the old partners in accordance with their profit and loss ratios. Therefore the entry to record the bonus to the old partners would be as follows: Cash

20,000 A, Capital B, Capital C, Capital

1,000 1,000 18,000

16 Withdrawal of a Partner (a) Usually a withdrawing partner shall withdraw assets, equal to the current value of the partner’s equity. (b) Appraisals and revaluation’s are necessary in order to determine the current value if the partnership assets and liabilities. (c) A withdrawing partner may take cash, any combination of partnership assets or a promissory note from the partnership. 17 Death of a Partner (a) Automatically dissolves the partnership. (b) The deceased partner’s estate is entitled to receive the amount of the partner’s equity interest. (c) There is an immediate closing of the books to determine the earnings since the end of the previous accounting period up to the date of the partner’s death. (d) The balance in the capital account of the deceased partner is transferred to a liability account to the deceased’s estate. 18 Liquidation of the Partnership (a) All assets are converted to cash

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(b) Any gain or loss upon conversion is allocated to the partners capital accounts based upon their profit and loss ratios. (c) The creditors are paid first. (d) Any remaining cash is distributed to the partners. (e) If there is not enough available cash to pay the creditors in full, then a contribution must be made by the partners to cover the deficiency. Remember the creditors have a priority claim on the assets of the partnership before the owners. Note: The liquidating process may extend over a long period of time as the assets are being sold. This delays the distribution of cash to the partners but does not affect the amount that each partner will receive. (f) The partnership is dissolved.

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