© The McGraw-Hill Companies, Inc., 2007 Appendix D Accounting for Partnerships

© The McGraw-Hill Companies, Inc., 2007 Conceptual Chapter Objectives C1: Identify characteristics of partnerships and similar organizations

© The McGraw-Hill Companies, Inc., 2007 Analytical Chapter Objectives A1: Compute partner return on equity and use it to evaluate partnership performance

© The McGraw-Hill Companies, Inc., 2007 Procedural Chapter Objectives P1: Prepare entries for partnership formation P2: Allocate and record income and loss among partners P3: Account for the admission and withdrawal of partners P4: Prepare entries for partnership liquidation

© The McGraw-Hill Companies, Inc., 2007 Partnership Form of Organization Partnership Agreement Voluntary Association Limited Life Taxation Unlimited Liability Mutual Agency Co- Ownership of Property C1

© The McGraw-Hill Companies, Inc., 2007 Organizations with Partnership Characteristics Limited Partnerships (LP) General partners assume management duties and unlimited liability for partnership debts. Limited partners have no personal liability beyond invested amounts. General partners assume management duties and unlimited liability for partnership debts. Limited partners have no personal liability beyond invested amounts. Limited Liability Partnerships (LLP) Protects innocent partners from malpractice or negligence claims. Most states hold all partners personally liable for partnership debts. Protects innocent partners from malpractice or negligence claims. Most states hold all partners personally liable for partnership debts. Limited Liability Corporation s (LLC) Owners have same limited liability feature as owners of a corporation. A limited liability corporation typically has a limited life. Owners have same limited liability feature as owners of a corporation. A limited liability corporation typically has a limited life. C1

© The McGraw-Hill Companies, Inc., 2007 Choosing a Business Form Many factors should be considered when choosing the proper business form. C1

© The McGraw-Hill Companies, Inc., 2007 Organizing a Partnership Partners can invest both assets and liabilities in the partnership. Assets and liabilities are recorded at an agreed- upon value, normally fair market value. Asset contributions increase the partner’s capital account. Withdrawals from the partnership decrease the partner’s capital account. P1

© The McGraw-Hill Companies, Inc., 2007 Organizing a Partnership On 2/15/08, Smith and Jones form a partnership. Smith contributes $80,000 cash. Jones contributes land valued at $40,000. P1

© The McGraw-Hill Companies, Inc., 2007 Dividing Income or Loss Three frequently used methods to divide income or loss are allocation on: 1. Stated ratios. 2. Capital balances. 3. Services, capital and stated ratios. Three frequently used methods to divide income or loss are allocation on: 1. Stated ratios. 2. Capital balances. 3. Services, capital and stated ratios. Partners are not employees of the partnership but are its owners. This means there are no salaries reported as expense on the income statement. Profits or losses of the partnership are divided on some agreed upon ratio. P2

© The McGraw-Hill Companies, Inc., 2007 Allocation Based on Stated Ratios Smith and Jones agree to divide profits or losses ¾ for Smith and ¼ for Jones. For 2008, the partnership reported net income of $60,000. $60,000 × ¾ = $45,000 P2

© The McGraw-Hill Companies, Inc., 2007 Allocation Based on Capital Balances Smith’s capital balance, before division of profits or losses is $80,000 and Jones’s capital balance is $40,000. The partnership agreement calls for income or loss to be allocated based on the relative capital balances. Net income for 2008 is $60,000. P2

© The McGraw-Hill Companies, Inc., 2007 Allocation Based on Capital Balances Smith’s capital balance, before division of profits or losses is $80,000 and Jones’s capital balance is $40,000. The partnership agreement calls for income or loss to be allocated based on the relative capital balances. Net income for 2008 is $60,000. P2

© The McGraw-Hill Companies, Inc., 2007 Allocation Based on Services, Capital, and Stated Ratios Smith and Jones have a partnership agreement with the following conditions: Smith receives $15,000 and Jones receives $10,000 as annual salaries. Each partner is allowed an annual interest allowance of 5% on the beginning-of-year capital balance. Any remaining balance of income or loss is allocated equally. Net income for 2008 is $60,000. Smith and Jones have a partnership agreement with the following conditions: Smith receives $15,000 and Jones receives $10,000 as annual salaries. Each partner is allowed an annual interest allowance of 5% on the beginning-of-year capital balance. Any remaining balance of income or loss is allocated equally. Net income for 2008 is $60,000. P2

© The McGraw-Hill Companies, Inc., 2007 Allocation Based on Services, Capital, and Stated Ratios $80,000 × 5% = $4,000 $29,000 × ½ = $14,500 P2

© The McGraw-Hill Companies, Inc., 2007 Partnership Financial Statements Assume that during 2008, Smith withdrew $5,000 cash from the partnership and Jones withdrew $1,000. P2

© The McGraw-Hill Companies, Inc., 2007 Allocation Based on Services, Capital, and Stated Ratios Smith and Jones have a partnership agreement with the following conditions: Smith receives $15,000 and Jones receives $10,000 as annual salaries. Each partner is allowed an annual interest allowance of 5% on the beginning-of-year capital balance. Any remaining balance of income or loss is allocated equally. Net income for 2008 is $30,000. Smith and Jones have a partnership agreement with the following conditions: Smith receives $15,000 and Jones receives $10,000 as annual salaries. Each partner is allowed an annual interest allowance of 5% on the beginning-of-year capital balance. Any remaining balance of income or loss is allocated equally. Net income for 2008 is $30,000. P2

© The McGraw-Hill Companies, Inc., 2007 Allocation on Services, Capital, and Stated Ratios ($1,000) × ½ = $500 P2

© The McGraw-Hill Companies, Inc., 2007 Admission and Withdrawal of Partners When the makeup of the partnership changes, the partnership is dissolved. A new partnership may be immediately formed. New partner acquires partnership interest by: 1. Purchasing it from the other partners, or 2. Investing assets in the partnership. When the makeup of the partnership changes, the partnership is dissolved. A new partnership may be immediately formed. New partner acquires partnership interest by: 1. Purchasing it from the other partners, or 2. Investing assets in the partnership. P3

© The McGraw-Hill Companies, Inc., 2007 Admission of a Partner A new partner can purchase partnership interest directly from the existing partners.  The cash goes to the partners, not to the partnership. To become a partner, the new partner must be accepted by the current partners. A new partner can purchase partnership interest directly from the existing partners.  The cash goes to the partners, not to the partnership. To become a partner, the new partner must be accepted by the current partners. Purchase of Partnership Interest P3

© The McGraw-Hill Companies, Inc., 2007 On January 2, 2009, Jones agrees to sell Johnson $10,000 of her partnership interest for $25,000 cash. Smith agrees with this. arrangement. Purchase of Partnership Interest P3

© The McGraw-Hill Companies, Inc., 2007 Investing Assets in a Partnership The new partner can gain partnership interest by contributing assets to the partnership. The new assets will increase the partnership’s net assets. After admission, both assets and equity will increase. The new partner can gain partnership interest by contributing assets to the partnership. The new assets will increase the partnership’s net assets. After admission, both assets and equity will increase. P3

© The McGraw-Hill Companies, Inc., 2007 On January 2, 2009, Smith and Jones agree to accept Johnson as a partner upon his investment of $30,000 cash in the partnership. Investing Assets in a Partnership P3

© The McGraw-Hill Companies, Inc., 2007 Bonus to Old or New Partners Bonus to Old Partners When the current value of a partnership is greater than the recorded amounts of equity, the old partners usually require a new partner to pay a bonus when joining. Bonus to New Partners The partnership may grant a bonus to a new partner if the business is in need of cash or if the new partner has exceptional talents. P3

© The McGraw-Hill Companies, Inc., 2007 Bonus to Old Partners On January 2, 2009, Smith and Jones agree to accept Johnson as a partner upon his investment of $60,000 cash in the partnership. Johnson is to receive a 20% ownership interest in the new partnership. Any bonus is attributable to the existing partners and is shared equally. P3

© The McGraw-Hill Companies, Inc., 2007 Bonus to Old Partners On January 2, 2009, Smith and Jones agree to accept Johnson as a partner upon his investment of $60,000 cash in the partnership. Johnson is to receive a 20% ownership interest in the new partnership. Any bonus is attributable to the existing partners and is shared equally. $60,000 - $46,800 = $13,200 × ½ = $6,600 P3

© The McGraw-Hill Companies, Inc., 2007 Bonus to New Partner On January 2, 2009, Smith and Jones agree to accept Johnson as a partner upon his investment of $60,000 cash in the partnership. Johnson is to receive a 30% ownership interest in the new partnership. Any bonus is attributable to the new partner and is shared equally by the existing partners. P3

© The McGraw-Hill Companies, Inc., 2007 Bonus to New Partner On January 2, 2009, Smith and Jones agree to accept Johnson as a partner upon his investment of $60,000 cash in the partnership. Johnson is to receive a 30% ownership interest in the new partnership. Any bonus is attributable to the new partner and is shared equally by the existing partners. $70,200 - $60,000 = $10,200 × ½ = $5,100 P3

© The McGraw-Hill Companies, Inc., 2007 Withdrawal of a Partner A partner can withdraw in two ways: The partner can sell his/her partnership interest to another person. The partnership can distribute cash and/or other assets to the withdrawing partner. A partner can withdraw in two ways: The partner can sell his/her partnership interest to another person. The partnership can distribute cash and/or other assets to the withdrawing partner. P3

© The McGraw-Hill Companies, Inc., 2007 Withdrawal of a Partner Jones has a capital balance of $65,500. She decides to withdraw from the partnership of Smith, Jones, and Johnson for $50,000 cash. Any bonus is attributable to the remaining partners and is divided equally. $65,500 - $50,000 = $15,500 × ½ = $7,750 P3

© The McGraw-Hill Companies, Inc., 2007 Liquidation of a Partnership When a partnership is dissolved, four steps are required:  Noncash assets are sold for cash and a gain or loss on liquidations is recorded.  Gain or loss on liquidation is allocated to partners using their income-and-loss ratio.  Liabilities are paid or settled.  Any remaining cash is distributed to partners based on their capital balances. When a partnership is dissolved, four steps are required:  Noncash assets are sold for cash and a gain or loss on liquidations is recorded.  Gain or loss on liquidation is allocated to partners using their income-and-loss ratio.  Liabilities are paid or settled.  Any remaining cash is distributed to partners based on their capital balances. P4

© The McGraw-Hill Companies, Inc., 2007 No Capital Deficiency No capital deficiency means that all partners have a zero or credit balance in their capital accounts. Smith, Jones, and Johnson agree to dissolve their partnership. They sell all of their assets for a net gain of $10,000. Profits and losses are shared as follows: Smith, ½; Jones, ¼; and Johnson, ¼. P4

© The McGraw-Hill Companies, Inc., 2007 Capital Deficiency Capital deficiency means that at least one partner has a debit balance in his/her capital account. A partner with a deficit must, if possible, cover the deficit by paying cash into the partnership. Smith, Jones, and Johnson agree to dissolve their partnership. They sell all of their assets for a net loss of $10,000. Profits and losses are shared as follows: Smith, ½; Jones, ¼; and Johnson, ¼. P4

© The McGraw-Hill Companies, Inc., 2007 Capital Deficiency Any partner’s unpaid deficiency is absorbed by the remaining partners with credit balances in accordance with the partnership agreement. P4

© The McGraw-Hill Companies, Inc., 2007 Death of a Partner A partner’s death dissolves a partnership. A deceased partner’s estate is entitled to receive the equity. This usually requires closing the books to determine the net income or loss at the date of death and also recording market values for assets and liabilities. P4

© The McGraw-Hill Companies, Inc., 2007 Partner Return on Equity Partner return on equity Partner net income Average partner equity = A4

© The McGraw-Hill Companies, Inc., 2007 End of Appendix D