1. CHAPTER 8 8
Partnerships: Characteristics, Formation, and Accounting for Activities Fundamentals of Advanced Accounting 1st Edition Fischer, Taylor, and Cheng

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
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3. 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
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4. 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
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5. 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
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6. 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
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7. 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
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8. 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)
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9. The Drawing Account Illustrated
Debit
Periodic withdrawals of partnership assets
Credit
Closing of balance to partner’s capital account
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10. 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
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11. 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
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12. 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
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13. Initial Capital Investment – Journal Entry
Cash 10,000
Inventory 5,000
Office equipment 4,000
Note payable 2,000
Partner A, Capital 10,000
Partner B, Capital 7,000
Note: Office equipment is recorded at fair value
B’s capital account is reduce by loan assumed by the partnership
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14. Review – Partnership entries
Partner A loans partnership cash
DR Cash
CR Partner A, Capital
Personal debt of partner B paid by partnership
DR Partner B, Drawing
CR Cash
Partner B withdraws cash from partnership
Net income is divided between partners A & B
DR Income Summary
CR Partner B, Capital
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15. 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
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16. 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
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17. 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:
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18. Capital Investment of Partners (continued)
Interest is computed on beginning capital balances
Other alternatives:
Ending capital balances
Average capital balances (weighted average)
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19. 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
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20. Services Rendered by Partners - Example
Net Income = $120,000
Allocation of salaries = $60,000
Allocation of interest = $5,000
Bonus = 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
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21. 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
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22. Basic Schedule for Allocating Profits Illustration 8-2
Bonus is calculated as follows:
Bonus = 10% (Net income – Bonus)
Bonus = 10% (33,000 – Bonus)
Bonus x 110% = $3,300
Bonus = $3,000
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23. 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
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24. Deficiency Allocated By Order Of Priority
Profit allocation - Deficiency Allocated By P/L Ratio – Illustration 8-3
Bonus is calculated as follows:
Bonus = 10% (Net income – Bonus)
Bonus = 10% (22,000 – Bonus)
Bonus x 110% = $2,200
Bonus = $2,000
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25. Deficiency Allocated By Order Of Priority
Loss Allocation - Deficiency Allocated By P/L Ratio – Illustration 8-4
No bonus is calculated since it is based on a percentage of profit
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26. Deficiency Allocated By Order Of Priority
Profit allocation - Deficiency Allocated By Order of Priority – Illustration 8-5
Deficiency Allocated By Order Of Priority
Bonus is calculated as follows:
Bonus = 10% (Net income – Bonus)
Bonus = 10% (22,000 – Bonus)
Bonus x 110% = $2,200
Bonus = $2,000
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27. 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
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