3Advantages of a Partnership Objective 1Explain the major advantages and disadvantages of a partnershipAdvantages of a PartnershipIt pools the skills, abilities, and financial resources of two or more individuals.It is easy and inexpensive to form.A partnership does not pay income tax.A partnership is an association of two or more persons who carry on, as co-owners, a business for profit. In a business partnership, partners can create debts and they are liable for those debts. In a business partnership, each partner may have different duties to make the business function well. There are advantages and disadvantages of the partnership form of business.The advantages of the partnership form of business:Permits a pooling of skills, abilities, and financial resources.Easy to formNo federal income tax is levied on the net income of a partnership.Each partner is taxed individually on his or her share of the partnership’s income.
4Disadvantages of a Partnership Each partner has unlimited liability.The partnership is a mutual agency.The business lacks continuity. It has a limited life.Ownership rights are not freely transferable.The disadvantages of the partnership form of business:Unlimited liability for debts.Mutual agency: each partner may act as an agentLimited life: if one partner dies or is incapacitated, the existing partnership is dissolved.Partnership interest is not freely transferable.
5What is a partnership agreement? Explain the important provisions which should be included in a partnership agreementObjective 2QUESTION:What is a partnership agreement?A partnership agreement is a legal contract forming a partnership and specifying certain details of the operation.ANSWER:There are several important provisions which should be included in the partnership agreement when a partnership is formed.Like a prenuptial agreement, a partnership agreement is a legal contract forming a partnership and specifying certain details of the operation.A partnership agreement is legally known as the articles of partnership.
6Every partnership agreement should contain: Names of the partners.Name, location, and nature of the business.Starting date of the agreement.Life of the partnership.Rights and duties of each partner.Review this list of items which should be included in the partnership agreement.
7Every partnership agreement should contain: Amount of capital to be contributed by each partnerDrawings (withdrawals) by the partners.Fiscal year and accounting method.Method of allocating income or loss to the partners.Procedures to be followed if the partnership is dissolved or the business is liquidated.Additional items which should be included are shown. Remember that like a sole proprietorship a partnership will dissolve upon a partner’s death, incapacity, or withdrawal.
8Account for the formation of a partnership. Objective 3Account for the formation of a partnership.Memorandum entry to record formation of partnership.Investment of assets and liabilities by partners.Setting up partners’ capital accounts.Setting up partners’ drawing accounts.Subsequent investments and permanent withdrawals.Partnerships and sole proprietorships use the same types of journals and ledgers as well as asset, liability, revenue, and expense accounts.Instead of having just one capital account as in a sole proprietorship, a partnership will have a capital account and a withdrawal account for each partner.The first entry in the general journal of a new partnership is a memorandum entry (informational entry).The elements included in the memorandum entry to record the formation of a partnership:Name of the businessNames of the partnersOther pertinent information provided by the partnership agreement.The next journal entry records the partners contribution of assets and liabilities into the partnership in exchange for a share in the partnership. The initial values of the assets contributed by the partners should reflect fair market value at the time of contribution. (This may require professional appraisal.)
9Memorandum Entry to Record Formation of Partnership 20--Jan On this date a partnership wasformed between Ellen Barret and Jerry Reed to carry on aretail clothing business under the name of Old Army,according to the terms of thepartnership agreementeffective this date.Let’s look at the example of Ellen Barret, a sole proprietor of Old Army. She is forming a partnership with Jerry Reed.This is the first entry in the journal of the new partnership. It is the memorandum entry recording the formation of the partnership.
10Investments of Assets and Liabilities by a Sole Proprietor 20--Jan. 1 Accounts Receivable ,500.00Merchandise Inventory ,200.00Store Equipment ,000.00Allow. for Doubtful Accts ,200.00Notes Payable—Bank ,100.00Accounts Payable , Interest PayableEllen Barret, Capital ,200.00Investment of Ellen BarretIn the next journal entry, Ellen Barret transfers her assets from her sole proprietorship into the partnership in exchange for a $53,200 partnership interest.Assets that are transferred to a partnership should be appraised and recorded at the agreed-upon fair market value at the time of transfer.
11Investment of Cash by Partner New Partner Given Credit for Amount InvestedJan. 1Cash ,000.00Jerry Reed, Capital ,000.00Investment of cash by ReedJerry Reed, her new partner, invests cash into the partnership in exchange for a $28,000 partnership interest. In this partnership, two capital accounts exist—one for each partner.
12Drawing AccountsAny withdrawal by a partner, whether it is cash or some other asset, is a return of equity to that partner.The partner’s drawing account balance reduces that partner’s equity.The partnership will create a separate drawing account for each partner. Just like in a sole proprietorship, any withdrawal by a partner, whether it is cash or some other asset, is a return of equity to that partner and will reduce that partner’s equity in the business.
14Allocating Partnership Income or Loss Compute and record the division of net income or net loss between partners in accordance with the partnership agreementObjective 4Allocating Partnership Income or LossStep 1. Close revenue to Income Summary.Step 2. Close expenses to Income Summary.Step 3. Close Income Summary to the partners’ capital accounts.Step 4. Close each partner’s drawing account to the partner’s capital account.Partners can agree to any kind of distribution of income they desire. In the absence of an agreement to the contrary, partners share profits and losses equally.The primary difference in accounting for a partnership is in the closing process. Each partner has an equity account to which the balance in Income Summary must be closed. In step 3 of the closing process, the business determines the distributive share of net income or net loss which each partner will receive.In step 3 the business determines the distributive share for each partner.
15Allocation of Partnership Income or Loss Based on the partnership agreement.Allocated equally to each partner if the partnership agreement is “silent.”Income distribution does not mean cash distribution.The Distributive share is the amount of net income or net loss allocated to each partner.The allocation of partnership income or loss may be based on the partnership agreement or it may be allocated equally to each partner if the partnership agreement does not specify how the allocation should take place. Partnership income and loss can be allocated based on:an agreed upon ratio specified in the partnership agreement, orthe capital account balances of the partners
16Agreed Upon RatioExample: Barret and Reed agreed that net income should be split in a 3:2 ratio to Barret and Reed, respectively.Step 1: Add the figures given in the ratio.Barret+ Reed= TotalStep 2: Express each figure as a fraction of the total.Barret’s share /5Reed’s share /5Step 3: Convert each fraction into a percentage.Barret’s share /5 = 60%Reed’s share /5 = 40%The partnership agreement may establish a ratio by which the net income or net loss is divided.The ratio must be converted to a decimal or a fraction to compute the allocation. For example--the conversion of the 3/2 ratio (Barret/Reed) into a decimal (60/40) or a fraction (3/5 and 2/5).
17Agreed Upon Ratio Net Income X partner’s share percentage: Barret’s share ($100,000 x 60% = $60,000)Reed’s share ($100,000 x 40% = $40,000)20--Dec Income Summary ,000.00Ellen Barret, Capital ,000.00Jerry Reed, Capital ,000.00Here is the journal entry distributing the partnership’s income from the Income Summary account into the partner’s capital accounts based on a 60/40 ratio.
18Capital Account Balances Step 1: Add the capital account balances.Barret $53,200Reed ,000Total = $81,200Step 2: Express each balance as a fraction and convert it to a percentage.Barret $53,200/$81,200 = %Reed $28,000/$81,200 = %In this example, the allocation of net income was based on the capital account balances of the partners. We convert the partner’s share to a decimal. Barret would be entitled to % of net income and Reed will get %. Using this method of allocation, the ratio will vary from one period to the next, depending upon capital account balances.
19Capital Account Balances Net Income X partner’s share percentage:Net Income $100,000Barret $100,000 x % = $65,517Reed $100,000 x % = $34,483Barret will get % of the partnership’s $100,000 of net income or $65,517. Reed will get % of $100,000 or $34,883.
20Salary and Interest Allowances Allowances for partners’ salaries and interest on their investments can be included in the allocation of net income or loss.Allowances are debited to the Income Summary account and credited to the partners’ capital accounts.The remaining net income or loss is then allocated in the proper ratio.If salary allowances are part of the division of net income then an additional journal entry is required in the closing process to distribute a salary allowance to a partner. (Dr. Income Summary, Cr. partner’s Capital account).The remaining Income Summary balance is allocated to the partners’ Capital accounts based on the partnership agreement.
21Salary AllowancesSalary allowances are intended to reward the partners for the time they spend in the business and for the expertise and talents they bring to it.Salary allowances are withdrawals.Partners are not employees of the partnership so salary allowances are not treated like the wages of an employee but rather like withdrawals. Salary allowances are intended to reward the partners for the time they spend in the business and for the expertise and talents they bring to it. Salary allowances are part of the division of net income.Salary allowances do not represent salary expense.
22Salary Allowances Net Income is $112,800. Salary allowances for Barret $30,000 and Reed is $22,800.20--Dec Income Summary ,800.00Ellen Barret, Capital ,000.00Jerry Reed, Capital ,800.00This is the additional journal entry which is required in the closing process to distribute a $30,000 salary allowance to Ellen Barret and a $22,800 salary allowance to her partner Jerry Reed. The remaining net income ($112,800- $52,800 = $50,000) will be distributed to the partners’ capital account balances based on the 60/40 ratio.
23Salary Allowances Net Income $112,800 Less: Salary Allowances – 52,800 Balance in Income Summary = $ 60,000Using the agreed upon ratio, the amount of net income after salary allowances is allocated 60% to Barret and 40% to Reed.20--Dec Income Summary ,000.00Ellen Barret, Capital ,000.00Jerry Reed, Capital ,000.0060% of the remaining Income Summary balance of $50,000 ($36,000) is allocated to Ellen Barret’s capital account and 40% ($24,000)is allocated to Jerry Reed’s capital account balance.
24Net Loss Their capital accounts are debited (decreased). Assume net loss = $30,000Record the salary allowances of $30,000 for Barret and $22,800 for Reed.Record the interest allowances of $4,256 to Barret and $2,240 to Reed.Income SummaryNet Loss 30,000Dec. 31Sal. All ,800Sometimes a partnership agrees to pay each partner interest on their capital balances as a way to recognize their capital investments in the partnership. Partners may recognize their capital investments by allowing each partner a percentage of interest on their capital balance at the start of the period. Assume that Barret and Reed each have a 8 percent interest allowance.If the Barret and Reed partnership has a net loss during the period, the allocation would take place as follows:First any salary allowances are distributed, thenany interest allowance is distributed and thenfinally the large debit balance in Income Summary is allocated to the partner’s capital account balances in the 60/40 ratio.In this situation, to close Income Summary the account would be credited and each of the partners’ capital accounts would be debited (reduced).Dec. 31Int. All ,496Bal $89,296Distributed between Ross and Wright.Their capital accounts are debited (decreased).
25Partnership Financial Statements Objective 5Prepare a statement of partners’ equitiesPartnership Financial StatementsIncome StatementSame as that for a sole proprietorship.One exception—on the bottom of the statement, the division of net income is shown between the partners.Balance SheetSame as that for a sole proprietorship.One exception—there exists a separate capital account for each of the partners in Partner’s Equity section.Time to prepare the financial statements of the partnership. The Statement of Partner’s Equities contains the details of the partners’ capital accounts.For the most part, financial statements for a partnership are identical to those of a sole proprietorship with exception of the allocation of net income. The balance sheet usually lists only the partner’s capital balances at the end of the accounting period.
26Statement of Partners’ Equities OLD ARMYStatement of Partners’ EquitiesYear Ended December 31, 2010Barret Reed TotalCapital Capital CapitalCapital Balances, Jan. 1,Investment During Year , , ,200.00Net Income (Loss) for Year , (2,908.00) 3,400.00Totals , , ,600.00Less Withdrawals During Year , , ,800.00Capital Balances, Dec. 31, , , ,800.00The Statement of Partners’ Equities is similar to the Statement of Owner’s Equity in a sole proprietorship. It contains:Beginning capitalAdditional investmentsShare of net income or net lossWithdrawalsEnding capitalHere is Old Army’s Statement of Partner’s Equities for the year ending December 31, Since this is the first year of the partnership, beginning capital balances are $0. The statement shows the investments of each partner, their share of the partnership’s income and the withdrawals (salaries) each partner made during the period.Each partner’s salary is treated as a withdrawal on the statement.
28Account for the revaluation of assets and liabilities prior to the dissolution of a partnership Objective 6DissolutionStep 1Accounting records are closed.Net income or net loss on the date of dissolution is recorded and transferred to the partners’ capital accounts.Step 2Assets and liabilities are revalued at fair market value.When there is a change in partners (death, withdrawal, admission of new) the old partnership is dissolved and a new partnership is formed. A dissolution is the legal termination of a partnership. A liquidation is the termination of a business by distributing all assets and discontinuing the business. When a partnership is dissolved then all of the assets and liabilities are revalued.There are certain steps to follow when a partnership is dissolved:Step 1Accounting records are closed.Net income or net loss on the date of dissolution is recorded and transferred to the partners’ capital accounts.Step 2Assets and liabilities are revalued at fair market value.
29Asset RevaluationWhen transferred from one partnership to another, assets are revalued to their fair market value.The new value will not necessarily agree with the book value carried by the old firm.The revaluation of assets affects the balance sheet only.Assets are written up or down based upon the revaluation of the assets. Then, any differences between the book value and the appraised value are allocated to the old partner’s Capital accounts. The allocation is made in accordance with the formula for sharing net income or loss. The “revaluation” takes place prior to the partner change.
30An adjusting entry is prepared for the revalued items. GENERAL JOURNAL PAGEDATE DESCRIPTION POST DEBIT CREDITREF.20--April Merchandise Inventory ,000.00Allow. for Doubtful Accounts ,300.00Tom Lee, Capital ,680.00Joan Wilner, Capital 2,680.00Nau Flores, Capital ,340.00To record revaluation ofassets and allocation ofgain to partners.An adjusting entry is prepared for the revalued items. In this journal entry, Merchandise Inventory is increased by $9,000 and Allowance for Doubtful Accounts is increased by $2,300. The gain (from the re-evaluation) is allocated to each of the existing partners’ capital accounts.An adjusting entry is prepared for the revalued items.
31Admission of a New Partner Objective 7Account for the sale of a partnership interestAdmission of a New PartnerThere are two ways a new partner may be admitted to the partnership:By purchasing all or part of the interest of an existing partner and paying that partner directly.By investing cash or other assets directly in the existing partnership.When a new partner is admitted to a partnership, business law dictates that the original partnership “ends” and the new partnership “begins” with the new partner. (The business continues and does not in fact end. However, the business needs to record its net income for the period just prior to the admission of a new partner.) There are two ways a new partner may be admitted to the partnership:By purchasing all or part of the interest of an existing partner and paying that partner directly.By investing cash or other assets directly in the existing partnership.
32Objective 8Account for the investment of a new partner in an existing partnership.A new partner may purchase an interest in a partnership by contributing assets (money or other property) to the partnership directly.The new partner may receive credit for the amount invested or for a higher or lower amount.Let’s see how we would account for a new partner joining the partnership.
33New Partner Given Credit for Amount Invested 20--April 1Cash ,500.00Beth Rivera, Capital ,500.00To record investment of Rivera for one-fourth interest in partnership.The first step in calculating the amount to credit to a new partner is to compute the total amount of capital after the new partner’s contribution. Total partnership capital after the investment of $51,500 of the new partner = $206, Beth Rivera, the new partner wanted to buy ¼ interest in the partnership. ¼ of $206,000 = $51,500. She is given credit for exactly the amount she invested.New partner, Rivera, pays $51,500 for ¼ interest in partnership.
34New Partner Given Credit for More Than Amount Invested New partner paid $45,500 for one-fourth interest in partnership. (¼ of partnership capital = $50,000)20--April Tom Lee, Capital ,800.00Joan Wilner, Capital ,800.00Nau Flores, CapitalBeth Rivera, Capital ,500.00To record bonus allowednew partnerLet’s see what happens when the new partner gives less than the percentage of partnership she is receiving.Again, the first step in calculating the amount to credit to a new partner is to compute the total amount of capital after the new partner’s contribution.Total partnership capital after her investment of $45,500 is $200,000. ¼ of the partnership would be = $50,000 of the new existing total capital.Since Beth Rivera only gave $45,000 to purchase the $50,000 interest, she gets a bonus of $4,500. This bonus is removed from the capital accounts of the other partners. (This journal entry shows the bonus being distributed to her capital account)Giving a new partner credit for more than the amount invested is commonly referred to as “giving a bonus” to the new partner.After the cash investment is recorded, a bonus is given to the new partner by crediting the new partner’s capital account. This credit is offset by debits to the original partners’ capital accounts.
35New Partner Given Credit for Less Than Amount Invested 20--April Beth Rivera , Capital ,500.00Tom Lee, Capital ,200.00Joan Wilner, Capital ,200.00Nau Flores, Capital ,100.00To record bonus to originalpartners.If a new partner is given credit for less than the amount invested, a bonus is allowed to the existing partners and is credited to their capital accounts in the former profit and loss ratio.In this journal entry, the new partner gave $5,500 more than the amount of the interest she acquired in the partnership so a bonus is given to the original partners.If a new partner is given credit for less than the amount invested, a bonus is allowed to the existing partners and is credited to their capital accounts in the former profit and loss ratio.
36Account for the withdrawal of a partner from a partnership Objective 9Account for the withdrawal of a partner from a partnershipWhen a partner withdraws, the payment given to the withdrawing partner may be more or less than the withdrawing partner’s capital balance.The difference in the cash payment and the withdrawing partner’s capital account is debited or credited to the remaining partners according to their profit-and-loss ratio.Upon the withdrawal of a partner, the books of the partnership must be closed and the assets and liabilities revalued.A partner who leaves the partnership will want to reap the benefit of past efforts in the partnership In general, the departing partner will either take cash to close his or her equity account or will sell outright the partnership interest to a third party. (Most partnership agreements however, restrict the sale of a partnership interest.) The difference in the cash payment and the withdrawing partner’s capital account is debited or credited to the remaining partners according to their profit-and-loss ratio.
37(Paid the balance of her capital account.) Withdrawal of Partner(Paid the balance of her capital account.)New Partner Given Credit for Amount Invested20--Mar. 31Nau Flores, Capital ,340.00Cash ,340.00To record cash payment made to Flores on withdrawal from partnership.This is the journal entry to pay the withdrawing partner, Nau Flores, the balance of her capital account after the revaluation process.The revalued assets result in the following capital account balances:Lee $40,980Wilner ,180Flores ,340Total $154,500
38Withdrawing Partner’s Capital Account If the amount paid is higher than the withdrawing partner’s capital account balance, the excess is debited to the capital accounts of the remaining partners according to their income and loss ratio.If the amount paid is less than the withdrawing partner’s capital account balance, the difference is credited to the remaining partners’ capital accounts based on their income and loss ratio.There are other procedures for determining how the withdrawing partner’s capital account will be affected. Take a moment to review the procedures that will be demonstrated in the next slide.
39(Paid more than the balance of her capital account.) Withdrawal of Partner(Paid more than the balance of her capital account.)New Partner Given Credit for Amount Invested20--Mar. 31Nau Flores, Capital ,340.00Tom Lee, Capital ,500.00Joan Wilner, Capital ,500.00Cash ,340The revalued assets result in the following capital account balances:Lee $40,980Wilner ,180Flores ,340Total $154,500This is the journal entry to pay the withdrawing partner, Nau Flores, the balance of her capital account after the revaluation process. Because she is paid $9,000 more than her capital balance, the difference (or bonus) is debited to the remaining partners’ capital accounts.Flores receives a bonus of $61, ,340 = $9,000The bonus comes out of the remaining partner’s capital accounts.