1. Copyright © by Houghton Miffin Company. All rights reserved.1 Principles of Financial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College

2. Chapter 13 Partnerships

3. Copyright © by Houghton Miffin Company. All rights reserved.3 LEARNING OBJECTIVES 1.Identify the principal characteristics, advantages, and disadvantages of the partnership form of business. 2.Record partners’ investments of cash and other assets when a partnership is formed. 3.Compute and record the income or losses that partners share, based on stated ratios, capital balance ratios, and partners’ salaries and interest.

4. Copyright © by Houghton Miffin Company. All rights reserved.4 4.Record a person’s admission to a partnership. 5.Record a person’s withdrawal from a partnership. 6.Compute the distribution of assets to partners when they liquidate their partnership. LEARNING OBJECTIVES (continued…)

5. OBJECTIVE 1 Identify the principal characteristics, advantages, and disadvantages of the partnership form of business. Partnership Characteristics

6. Copyright © by Houghton Miffin Company. All rights reserved.6 u “... an association of two or more persons to carry on as co-owners of a business for profit.” u Partnerships are treated as separate accounting entities.Partnerships

7. Copyright © by Houghton Miffin Company. All rights reserved.7 u A partnership is a voluntary association of individuals rather than a legal entity in itself. u A partner has unlimited liability for the debts of the partnership. Partnership Characteristics

8. Copyright © by Houghton Miffin Company. All rights reserved.8 u A partnership is formed via a partnership agreement. u The agreement specifies: 4 The name, location and purpose of the business 4 The partners and their duties 4 The investments of each partner 4 The methods for distributing income and losses 4 The procedures for the admission and withdrawal of partners. 4 The withdrawal of assets allowed each partner. 4 The liquidation of the business Partnership Characteristics (continued…)

9. Copyright © by Houghton Miffin Company. All rights reserved.9 u A partnership has a limited life. u A partnership is dissolved when: 4 A new partner is admitted. 4 A partner withdraws. 4 A partner goes bankrupt. 4 A partner is incapacitated. 4 A partner retires. 4 A partner dies. 4 The partnership ends per the partnership agreement. Partnership Characteristics ( continued…)

10. Copyright © by Houghton Miffin Company. All rights reserved.10 u Mutual agency: any partner can bind the partnership to a business agreement as long as he or she acts within the scope of the company’s normal operations. Partnership Characteristics (continued…)

11. Copyright © by Houghton Miffin Company. All rights reserved.11 u Unlimited liability. 4 All partners have unlimited liability for the partnership’s debt. 4 Creditors may seek payment from the personal assets of each partner. u Co-ownership of partnership property. 4 The property of a partnership is an asset of the partnership and is owned jointly by all partners. Partnership Characteristics (continued…)

12. Copyright © by Houghton Miffin Company. All rights reserved.12 u Participation in partnership income. 4 Each partner has the right to share in the company’s income and the responsibility to share in its losses. 4 The partnership agreement should state the method of distributing income and losses to each partner. 4 If the partnership agreement fails to detail how income and losses should be distributed, then they are distributed equally. Partnership Characteristics (continued…)

13. Copyright © by Houghton Miffin Company. All rights reserved.13 u Advantages: 4 Easy to form, change, and dissolve. 4 Facilitates the pooling of capital, resources and individual talents. 4 No corporate tax. 4 More flexibility than corporations. Partnership Advantages

14. Copyright © by Houghton Miffin Company. All rights reserved.14 u Disadvantages: 4 Limited life. 4 One partner can bind the partnership to a contract. 4 Unlimited personal liability. 4 Lack of transferability of ownership. 4 Difficult to raise large amounts of capital. Partnership Disadvantages

15. Copyright © by Houghton Miffin Company. All rights reserved.15 Other Forms of Association Limited Partnerships: 4 Limited partner’s liability limited to the amount of his or her investment. 4 One general partner with unlimited liability. Joint Ventures: 4 Alliances between companies to achieve a specific goal, often international. 4 May have agreed-upon limited life. 4 Partners may include governments.

16. Copyright © by Houghton Miffin Company. All rights reserved.16Discussion Q. Q.Identify whether each of the following characteristics is an advantage or a disadvantage of a partnership. 1. Taxation. 2. Transferability of ownership. 3. Freedom and flexibility. 4. Limited life.

17. Copyright © by Houghton Miffin Company. All rights reserved.17 A. 1. Advantage 2. Disadvantage 3. Advantage 4. Disadvantage

18. OBJECTIVE 2 Record partners’ investments of cash and other assets when a partnership is formed. Accounting for Partners’ Equity

19. Copyright © by Houghton Miffin Company. All rights reserved.19 Accounting for Partners’ Equity (continued…) u Owner’s equity is called partners’ equity. u Must maintain separate accounts for each partner.

20. Copyright © by Houghton Miffin Company. All rights reserved.20 Accounting for Partners’ Equity (continued…) u Each partner invests cash or other assets or a combination of the two in accordance with the partnership agreement. 4 Noncash assets are valued at their fair market value on the date of transfer to the partnership. 4 Invested assets are debited to the proper account and the partner’s capital account is credited for the total amount.

21. Copyright © by Houghton Miffin Company. All rights reserved.21 Accounting for Partners’ Equity (continued…) u Example: If Joe and Bob form a partnership and Joe invests a truck (FMV = $10,000) and Bob invests $5,000 cash the following entry would be made: u Cash 5,000 Truck 10,000 Joe, Capital10,000 Bob, Capital 5,000 To record the initial investment

22. Copyright © by Houghton Miffin Company. All rights reserved.22 Discussion Q. Q. If Bob, a partner, invests a computer that cost him $2,000 and has a current fair market value of $1,000, by what amount would his capital account be increase? A. A. Non-cash assets are valued at fair market value as of the date of investment. Thus, Bob’s capital account would increase $1,000.

23. OBJECTIVE 3 Compute and record the income or losses that partners share, based on stated ratios, capital balance ratios, and partners’ salaries and interest. Distribution of Partnership Income and Losses

24. Copyright © by Houghton Miffin Company. All rights reserved.24 Distributing Income and Losses u Distribution method is typically detailed in partnership agreement. u If partnership agreement is silent then income/losses are shared equally. u If agreement only details income distribution, losses are distributed in the same ratio.

25. Copyright © by Houghton Miffin Company. All rights reserved.25 Distributing Income and Losses (continued…) u Partnership income normally has three components. 1.Return to the partners for the use of their capital (interest on partners’ capital). 2.Compensation for partners’ services (partners’ salaries). 3.Other income for any special characteristic individual partners bring to the partnership.

26. Copyright © by Houghton Miffin Company. All rights reserved.26 Distributing Income and Losses (continued…) u Several ways may be used for partners to share income are: 4 Stated ratios. 4 Capital balance ratios. 4 Salaries and interest then remainder based on stated ratios. n Salaries and interest are not expenses to the partnership.

27. Copyright © by Houghton Miffin Company. All rights reserved.27 Stated Ratios u The partnership agreement would state in what ratio partnership income is to be distributed to the partners. u For example: Assume $20,000 in income and Bob and Joe’s stated ratios are 75% and 25%, respectively. u Computation of income distribution: Bob (75% x $20,000) $15,000 Joe (25% x $20,000) 5,000 $20,000

28. Copyright © by Houghton Miffin Company. All rights reserved.28 Stated Ratios u The journal entry to show the distribution to Bob and Joe would be: Income Summary 20,000 Bob, Capital15,000 Joe, Capital 5,000 Distribution of income for the year to partners’ Capital accounts

29. Copyright © by Houghton Miffin Company. All rights reserved.29 Capital Balance Ratios u If invested capital produces the most income for the partnership, then income and losses may be distributed according to capital balance. u The ratio may be based on either: 4 Beginning capital balance. 4 Average capital balance.

30. Copyright © by Houghton Miffin Company. All rights reserved.30 Capital Balance Ratios (continued…) u Assume that Bob and Joe had beginning capital balances of $70,000 and $30,000, respectively. u If they distribute income based on beginning capital ratios the $20,000 income would be distributed: Bob 70,000 ÷ 100,000 = 70% x $20,000 = $14,000 Joe 30,000 ÷ 100,000 = 30% x $20,000 = 6,000 $20,000

31. Copyright © by Houghton Miffin Company. All rights reserved.31 Capital Balance Ratios u If the partners believe that their capital balances are going to change dramatically during the year, they can choose average capital balance ratios as a fairer means of distributing income and losses. u In calculating average capital balances, withdrawals during the period and investments during the period are weighted for the length of time they affected the capital balance.

32. Copyright © by Houghton Miffin Company. All rights reserved.32 Capital Balance Ratios u Assume that Bob and Joe had average capital balances of $60,000 and $20,000, respectively, and the average total capital is $80,000. u If they distribute income based on average capital ratios, the $20,000 income would be distributed: u Bob 60,000 ÷ 80,000 = 75% x 20,000 = $15,000 Joe 20,000 ÷ 80,000 = 25% x 20,000 = 5,000 $20,000

33. Copyright © by Houghton Miffin Company. All rights reserved.33 Salaries, Interest, and Stated Ratios u Partners generally do not contribute equally to a firm. u To make up for unequal contributions, a partnership can allow for partners’ salaries, interest on partners’ capital balances, or a combination of both in the distribution of income. u Remember partners’ “salaries and interest” are not an expense but rather a method of distribution of income or loss.

34. Copyright © by Houghton Miffin Company. All rights reserved.34 Salaries, Interest, and Stated Ratios (continued…) Assume Joe and Bob’s partnership agreement allows distribution of income for salaries with interest on capital balances and any excess distributed equally. Step One - Distribution of Salaries: Income of Income PartnerDistributed Joe Bob Total income:$140,000 Dist. of Salaries: Joe $8,000 Bob$7,000 (15,000) Remaining income after salaries $125,000

35. Copyright © by Houghton Miffin Company. All rights reserved.35 Salaries, Interest, and Stated Ratios Step Two - Distribution of interest : Income of Income PartnerDistributed Joe Bob Remaining income after salaries $125,000 Distribution of Interest: Joe ($65,000 x.10) 6,500 Bob ($60,000 x.10) 6,000 (12,500) Remaining income after salaries and interest $112,500

36. Copyright © by Houghton Miffin Company. All rights reserved.36 Salaries, Interest, and Stated Ratios Step Three - Distribution of remainder : Income of Income PartnersDistributed Joe Bob Remaining income after salaries and interest $112,500 Remaining Dist. Equally Joe 56,250 Bob 56,250 (112,500) Income of Partners $70,750 $69,250 $140,000

37. Copyright © by Houghton Miffin Company. All rights reserved.37 Salaries, Interest, and Stated Ratios (continued…) u After all three steps have been completed, the distribution of the partnership income of $140,000 is: Joe Bob Total Income of partners$70,750$69,250 $140,000

38. Copyright © by Houghton Miffin Company. All rights reserved.38 Salaries, Interest, and Stated Ratios (continued…) u If the partnership agreement calls for the allocation of salaries or interest or both, they MUST be allocated to the partners even if there is insufficient income. u After such allocation the “deficit” will be shared equally.

39. Copyright © by Houghton Miffin Company. All rights reserved.39 Discussion Q.True or False: Partners’ salaries are one of the major expenses of a partnership. A.False. Partners’ salaries may be the basis for allocating income, not determining income.

40. OBJECTIVE 4 Record a person’s admission to a partnership. Dissolution of a Partnership

41. Copyright © by Houghton Miffin Company. All rights reserved.41 Dissolution of a Partnership Dissolution takes place through: 1.The admission of a new partner. 2.The withdrawal of a partner. 3.The death of a partner. After dissolution the remaining partners can: 4Act for the partnership in finishing its affairs. 4Form a new partnership.

42. Copyright © by Houghton Miffin Company. All rights reserved.42 Admission of a New Partner u The admission of a new partner dissolves the old partnership. u A partner may be admitted in one of two ways. 1.Purchasing an interest from an original partner. 2.Investing assets in the partnership.

43. Copyright © by Houghton Miffin Company. All rights reserved.43 Purchasing an Interest From a Partner u Each partner must agree to the change. u The transaction is a personal transaction between the old and new partners. u The interest purchased must be transferred from the Capital account of the old partner to the capital account of the new partner.

44. Copyright © by Houghton Miffin Company. All rights reserved.44 Admission of a New Partner u The entry to record a new partner who purchased the interest of an old partner would be: Old Partner, CapitalXX New Partner, CapitalXX u The book value is transferred, and the amount paid to the old partner is a personal matter and not entered into the partnership’s books.

45. Copyright © by Houghton Miffin Company. All rights reserved.45 Admission of a New Partner u If a new partner is admitted by investing assets in the partnership, both the assets and the partners’ equity in the firm increase. u Assume that Joe and Bob decide to admit Rosa into the partnership. They agree to give her one-third interest if she invests $75,000.

46. Copyright © by Houghton Miffin Company. All rights reserved.46 Admission of a New Partner u If Joe and Bob’s Capital accounts are $70,000 and $80,000, after Rosa’s investment the partnership capital would be: Joe$70,000 Bob 80,000 Rosa 75,000 Total $225,000 One-third interest = $225,000 ÷ 3 = $75,000

47. Copyright © by Houghton Miffin Company. All rights reserved.47 Admission of a New Partner (continued…) u The journal entry to record Rosa’s investment would be: Cash 75,000 Rosa, Capital75,000 Admission of Rosa to a one-third interest in the partnership

48. Copyright © by Houghton Miffin Company. All rights reserved.48 Bonus to the Old Partners u Sometimes a partnership may be so profitable that a new investor is willing to pay more than the actual dollar interest he or she receives in the partnership. u In this situation a “bonus” will result to the old partners. u This “bonus” should be distributed according to the terms of the partnership agreement.

49. Copyright © by Houghton Miffin Company. All rights reserved.49 Bonus to the Old Partners u When a bonus is due the old partners, the following journal entry would be made: CashXXX Old Partner, Capital XXX New Partner, Capital XXX

50. Copyright © by Houghton Miffin Company. All rights reserved.50 Bonus to the New Partner u In some cases the partners may admit a new partner and transfer part of their existing Capital balances to the new partner. u In this situation a “bonus” will result to the new partner. u This “bonus” should be absorbed by the old partners according to the terms of the partnership agreement.

51. Copyright © by Houghton Miffin Company. All rights reserved.51 Bonus to the New Partner (continued…) u When a bonus is due the new partner, the following journal entry would be made: Cash XXX Old Partner, Capital XXX New Partner, Capital XXX

52. Copyright © by Houghton Miffin Company. All rights reserved.52 Discussion Q. Why does the admission of a new partner who directly purchases the interest of an old partner result in no change in the assets of the partnership?

53. Copyright © by Houghton Miffin Company. All rights reserved.53 A. The entry to record a new partner who purchased the interest of an old partner would be: Old Partner, Capital XX New Partner, Capital XX The book value is transferred, and the amount paid to old partner is a personal matter and not entered into the partnership’s books.

54. OBJECTIVE 5 Record a person’s withdrawal from a partnership. Withdrawal of a Partner

55. Copyright © by Houghton Miffin Company. All rights reserved.55 Withdrawal of a Partner u When a partner decides to withdraw there are a number of considerations that should be spelled out in the partnership agreement. u Will an audit be performed? u How will the assets be reappraised? u How will a bonus be determined? u How will the withdrawing partner be paid?

56. Copyright © by Houghton Miffin Company. All rights reserved.56 Withdrawal of a Partner (continued…) u There are different ways a partner may withdraw. 4 Sell his or her interest to another partner(s) with the other partner(s)’ consent. 4 Sell his or her interest to an outsider with the consent of the other partner(s). 4 Withdraw assets equal to, less than, or greater than his or her capital balance.

57. Copyright © by Houghton Miffin Company. All rights reserved.57 Alternative Ways for a Partner to Withdraw

58. Copyright © by Houghton Miffin Company. All rights reserved.58 Withdrawal by Selling Interest u If a partner sells his or her interest to another partner or to an outsider with the consent of the other partners, the transaction is personal and does not change the partnership’s assets. u The balance in the selling partner’s Capital account is transferred to the new partner.

59. Copyright © by Houghton Miffin Company. All rights reserved.59 Withdrawal by Removing Assets u Debit the withdrawal partner’s capital account to give it a zero balance. u Credit the partnership’s asset accounts (e.g. Cash) for the amount of assets removed. u Credit a promissory note payable to the withdrawing partners for any excess of the capital account over assets removed, if any. u Credit each remaining partner’s capital account (according to their stated ratios) for any excess over assets removed as a bonus to the remaining partners.

60. Copyright © by Houghton Miffin Company. All rights reserved.60 Withdrawal by Removing Assets (continued…) u Example: Assume Rosa withdraws from the partnership when her Capital account has a balance of $60,000 and receives $40,000 cash. u In this situation Rosa is receiving less assets than her interest. u The equity she leaves ($20,000) is divided among the remaining partners according to their stated ratios.

61. Copyright © by Houghton Miffin Company. All rights reserved.61 Death of a Partner u When a partner dies, the partnership is dissolved because the original association has changed. u The partnership agreement should detail the steps to be taken upon death. u Normally, the books are closed and financial statements are prepared. u The remaining partners may purchase the deceased partner’s equity, sell it to outsiders, or transfer assets to the estate. u If the firm will continue, a new partnership must be formed.

62. Copyright © by Houghton Miffin Company. All rights reserved.62Discussion Q. What are the different ways a partner could withdraw from a partnership? A.There are different ways a partner may withdraw: n Sell his or her interest to another partner(s) with the other partner(s)’ consent. n Sell his or her interest to an outsider with the consent of the other partner(s). n Withdraw assets equal to, less than, or greater than his or her capital balance.

63. OBJECTIVE 6 Compute the distribution of assets to partners when they liquidate their partnership. Liquidation of a Partnership

64. Copyright © by Houghton Miffin Company. All rights reserved.64 Liquidation of a Partnership u Liquidation includes: 4 Ending the business. 4 Selling enough assets to pay the partnership’s liabilities. 4 Distributing any remaining assets among the partners. u The partnership agreement should indicate the procedures to be followed.

65. Copyright © by Houghton Miffin Company. All rights reserved.65 Liquidation of a Partnership u As the assets are sold, any gain or loss is distributed to the partners according to the stated ratios. u As cash becomes available, it is applied: 4 First, to partnership creditors (if any). 4 Second, to partners’ loans (if any). 4 Finally, to the partners’ capital balances.

66. Copyright © by Houghton Miffin Company. All rights reserved.66 Liquidation of a Partnership: Gain on Sale of Assets u Assume the Joe and Bob partnership had the following assets, liabilities, and equity: Cash $20,000 Inventory 15,000 Land 10,000 Accounts Payable $ 5,000 Joe, Capital 30,000 Bob, Capital 10,000 u Assume that they share income and losses equally.

67. Copyright © by Houghton Miffin Company. All rights reserved.67 Liquidation of a Partnership: Example u Assume they sell the inventory for $32,000 and the land for $14,000. Cash 46,000 Land10,000 Inventory15,000 Gain or Loss 21,000 from Realization To record sale of land and inventory upon liquidation u Cash balance is $66,000 ($20,000 + $46,000).

68. Copyright © by Houghton Miffin Company. All rights reserved.68 Liquidation of a Partnership: Example (continued…) u The realized gain of $21,000 is allocated based upon the partnership agreement (equally in this example). Realized Gain 21,000 on select land Joe, Capital10,500 Bob, Capital10,500 u Joe’s Capital account is now $40,500. u Bob’s Capital account is now $20,000.

69. Copyright © by Houghton Miffin Company. All rights reserved.69 Liquidation of a Partnership:Example (continued…) u The Accounts Payable are now paid off at their book value: Accounts Payable 5,000 Cash5,000 u The Cash account now has $61,000 which is equal to the partners’ equity, $40,500 + $20,500 (Assets = Liabilities + Partners’ Equity). u The cash is now distributed to Joe and Bob based upon their Capital account balances.

70. Copyright © by Houghton Miffin Company. All rights reserved.70 Loss on Sale of Assets Example 1: Loss Absorbed by Capital Balance u Assume the Joe and Bob partnership had the following assets, liabilities, and equity: Cash$20,000Accounts Payable$5,000 Inventory 15,000Joe, Capital 30,000 Land 10,000Bob, Capital 10,000 u Assume that they share income and losses equally.

71. Copyright © by Houghton Miffin Company. All rights reserved.71 Loss on Sale of Assets u Assume the inventory is sold for $14,000 and the land for $8,000. Cash22,000 Gain or Loss 3,000 from Realization Land 10,000 Inventory 15,000 To record sale of assets upon liquidation u Cash balance is now $42,000.

72. Copyright © by Houghton Miffin Company. All rights reserved.72 Distribution of Loss u The loss is distributed to the partners’ Capital accounts (equally in this example.) Joe, Capital 1,500 Bob, Capital1,500 Gain or Loss 3,000 from Realization To distribute realized loss. u Joe’s Capital account is now $28,500. u Bob’s Capital account is now $8,500.

73. Copyright © by Houghton Miffin Company. All rights reserved.73 Payment of Liabilities u The Accounts Payable are now paid off at Book Value: Accounts Payable 5,000 Cash 5,000 u Cash balance is how $37,000 which is equal to the partner equity: $28,500 + $8,500

74. Copyright © by Houghton Miffin Company. All rights reserved.74 Liquidation of a Partnership u If assets are sold for losses and a partner’s capital balance is insufficient to absorb the loss, then that partner must make up the deficit from her or his personal assets. u If the partner is unable to make up the deficit, then the remaining partners must share the loss based on their stated ratios.

75. Copyright © by Houghton Miffin Company. All rights reserved.75Discussion Q.What are the three steps in a liquidation of a partnership? A.Ending the business, selling enough assets to pay the partnership’s liabilities, and distributing any remaining assets among the partners.

76. Copyright © by Houghton Miffin Company. All rights reserved.76 1.Identify the principal characteristics, advantages, and disadvantages of the partnership form of business. 2.Record partners’ investments of cash and other assets when a partnership is formed. 3.Compute and record the income or losses that partners share, based on stated ratios, capital balance ratios, and partners’ salaries and interest. OK, LET’S REVIEW…

77. Copyright © by Houghton Miffin Company. All rights reserved.77 4.Record a person’s admission to a partnership. 5.Record a person’s withdrawal from a partnership. 6.Compute the distribution of assets to partners when they liquidate their partnership. AND ALSO…