Accounting Principles Second Canadian Edition Prepared by: Carole Bowman, Sheridan College Weygandt · Kieso · Kimmel · Trenholm

ACCOUNTING FOR PARTNERSHIPS CHAPTER 13

Chapter 13: Accounting For Partnerships Terms of the Partnership In order to establish the terms of the partnership and to protect yourself in the event of a disagreement or dissolution of a partnership, a partnership agreement should be drawn up. A partnership is an agreement in which two or more people combine resources in a business with a view to making a profit. What is a Partnership?

Advantages and Disadvantages Advantages of Partnership Ease of formation Low start-up costs Additional sources of investment capital Possible tax advantages Limited regulation Broader management base Disadvantages of Partnership Unlimited liability Divided authority Difficulty in raising additional capital Hard to find suitable partners Possible development of conflict between partners

Limited vs. General Most partnerships that are formed are general partnerships. In a general partnership, the owners share the management of a business, and each partner is personally liable for all debts and obligations incurred A limited partnership involves limited partners who combine only capital. They are not as involved in managing the business and cannot be liable for more than the amount of capital they have contributed. This is known as limited liability.

Transactions Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Each partner’s initial investment in a partnership should be recorded at the fair market value of the assets at the date of their transfer to the partnership. The values assigned must be agreed to by all of the partners.

Bert and Ernie begin a partnership. Bert invests $12,000 and Ernie invests $5,000 plus a computer valued at $800. The Entry to establish this business is: Cash17,000 Computer 800 Bert, Capital 12,000 Ernie, Capital 5,800 Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Example:

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership The partnership agreement should outline how income or loss is divided among partners. This is known as the income ratio. If there is no partnership agreement, or it is not covered in the partnership agreement, then all profits or losses are shared equally.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership The following are typical of the ratios that may be used: 1. A fixed ratio, expressed as a proportion (2:1), a percentage (67% and 33%), or a fraction (2/3 and 1/3). 2. A ratio based on either capital balances at the beginning of the year or on average capital balances during the year. 3. Salaries to partners and the remainder in a fixed ratio. 4. Interest on partners’ capital balances and the remainder in a fixed ratio. 5. Salaries to partners, interest on partners’ capital balances, and the remainder in a fixed ratio.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership The partnership of Adams, Harris and Downs divides income on an equal basis, they have earned a net income of $75,000. The entries would be Income Summary (or Revenue)$ J. Adams, Capital $ K. Harris, Capital $ T. Downs, Capital $ Example #1:

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Example #2: Jenny Adams and Kendall Harris have a partnership. Jenny has a capital balance of $ and Harris has a capital balance of $ Their partnership agreement states that they are to be given a salary of $7 000 each, an interest allowance of 5% on their capital balance and the remainder to be allocated at 40% for Adams and 60% for Harris. The business earned $24000 during the past year.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Example #2:

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership The admission of a new partner results in the legal dissolution of the existing partnership and the beginning of a new partnership. A new partner may be admitted either by: 1. Purchasing the interest of one or more existing partners, or 2. Investing assets in the partnership.

I. Purchase of a Partner’s Interest The admission of a partner by purchase of an interest in the firm is a personal transaction between one or more existing partners and the new partner. The price paid is negotiated and determined by the individuals involved; it may be equal to or different from the capital equity acquired. Any money exchanged is the personal property of the participants and not the property of the partnership. Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership I. Purchase of a Partner’s Interest

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership I. Purchase of a Partner’s Interest Why did Jenny and Kendall's capital only go up $ when Ted paid them $ each? The purchase is a personal transaction. The $2000 extra goes directly to Jenny and Kendall. Ted paid the extra amount because he thinks that the business will do well.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership When a partner is admitted by investment, both the total net assets and the total partnership capital change. When the new partner’s investment differs from the capital equity acquired, the difference is considered a bonus either to: 1) the existing (old) partners or 2) the new partner.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to existing partners The procedure for determining the new partner’s capital credit and the bonus to the old partners is as follows: 1.Determine the total capital of the new partnership by adding the new partner’s investment to the total capital of the old partnership. 2.Determine the new partner’s capital credit by multiplying the total capital of the new partnership by the new partner’s ownership interest. 3.Determine the amount of bonus by subtracting the new partner’s capital credit from the new partner’s investment. 4.Allocate the bonus to the old partners on the basis of their income ratios.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to existing partners Jenny Adams and Kendall Harris have a partnership and each have $ in their capital accounts. The partnership has been in operation for three years now and is very successful. Ted Downs wants to become a partner of the business with a 20% ownership share. Ted is going to invest $

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to existing partners Step 1 - Calculate the total capital of the new partnership. Add the capital of the existing partners and the investment of the new partner.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to existing partners Step 2 - Calculate the amount of capital of the new partner. This is done by multiplying the total capital of the new business by the percent of ownership to which the new partner agreed. In this example, Ted Downs agreed to a 20% ownership share: $ X.20 = $32 000

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to existing partners Step 3 - Calculate the amount of the bonus to be allocated to the existing partners. This is done by taking the investment of the new partner and subtracting the amount of capital to be allocated as calculated in step 2. $ $ = $8000

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to existing partners Step 4 - Record the entry to admit the new partner, allocating the bonuses to the existing partners based on their income ratios. In this case, Jenny and Kendall agreed to divide all income or losses equally, therefore each of their capital accounts will increase $4000 ($8000 total bonus divided in half).

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to existing partners

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to new partners Jenny Adams and Kendall Harris have a partnership and each have $ in their capital accounts. The partnership has been in operation for three years now, and Jenny and Kendall have decided to expand the manufacturing unit of the business. They approached Ted Downs because he is currently running the manufacturing section of another company. Ted is excited about becoming a partner, but is hesitant about leaving his current, well-paying job. Jenny and Kendall offer Ted a one-third share of the partnership if Ted agrees to invest $ Ted agrees.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to new partners Step 1 - Calculate the total capital of the new partnership. Add the capital of the existing partners and the investment of the new partner.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to new partners Step 2 - Calculate the amount of capital of the new partner. This is done by multiplying the total capital of the new business by the percent of ownership to which the new partner agreed. In this example, Ted Downs agreed to a one-third ownership share: $ X 1/3= $50 000

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to new partners Step 3 - Calculate the amount of the bonus to be allocated to the new partner. This is done by taking the capital of the new partner as calculated in step 2, and subtracting the amount invested. $ $ = $20 000

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to new partners Step 4 - Record the entry to admit the new partner, allocating the bonus to the new partner, and decreasing the existing partner's capital accounts based on their income ratios. In this case, Jenny and Kendall agreed to divide all income or losses equally; therefore, each of their capital accounts will decrease $ ($ total bonus divided in half).

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership II. Investing assets in the partnership Bonus to new partners

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership A partner may withdraw from a partnership voluntarily by selling his or her equity in the firm or involuntarily by dying. The withdrawal of a partner may be accomplished by 1. payment from remaining partners’ personal assets or 2. payment from partnership assets.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Existing Partners Using Personal Funds to Buy Out Partner If a partner is leaving, the remaining partners may choose to buy him/her out with their personal money. As is the case when a new partner buys an existing partner's ownership share, this is a personal transaction between the partners, and the only change on the books of the business will be a change in the capital accounts.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Existing Partners Using Personal Funds to Buy Out Partner Example: Jenny Adams, Kendall Harris and Ted Downs have a partnership with $80 000, $ , and $ in their capital accounts, respectively. Jenny has worked hard over the years and wants to retire. Kendall and Ted offer Jenny $ each ($ total) for a 50% share of her capital. Jenny accepts. The entry would be:

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Payment from Assets Bonus to Withdrawing Partner Jenny Adams, Kendall Harris, and Ted Downs have a partnership with $ , $ and $ respectively in their capital accounts. They have an income ratio of 4:3:2. The partnership has been in operation for fifteen years now and is very successful. Ted Downs wants to retire and he leaving the business on friendly terms. He receives a cash payout of $ on Nov. 1.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Step 1- Calculate the amount of the bonus to be allocated to the outgoing partner. This is done by taking the amount of the payout and subtracting the balance in the capital account. $ $ = $ Payment from Assets Bonus to Withdrawing Partner

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Step 2- Record the entry of the outgoing partner, allocating the bonus to the existing partners based on their income ratios. In this case, the bonus of $ is divided as follows: Jenny Adams: $ X 4/7 = $ Kendall Harris: $ X 3/7 = $ Payment from Assets Bonus to Withdrawing Partner

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Payment from Assets Bonus to Withdrawing Partner

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Payment from Assets Bonus to Remaining Partners Jenny Adams, Kendall Harris, and Ted Downs have a partnership with $ , $ and $ respectively in their capital accounts. They have an income ratio of 4:3:2. Ted Downs wants to retire and he leaving the business because it has been struggling. He receives a cash payout of $ on Nov. 1.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Payment from Assets Bonus to Remaining Partners Step 1- Calculate the amount of the bonus to be allocated to the remaining partners. This is done by taking the balance in the capital account and subtracting the amount of the payout. $ $ = $35 000

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Payment from Assets Bonus to Remaining Partners Step 2- Record the entry of the outgoing partner, allocating the bonus to the existing partners based on their income ratios. In this case, the bonus of $35000 is divided as follows: Jenny Adams: $ X 4/7 = $ Kendall Harris: $ X 3/7 = $15 000

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Payment from Assets Bonus to Remaining Partners As you can see above, the result of allocating a bonus to the existing partners is an increase in the capital accounts of the existing partners. This is because Ted was paid less than the balance in his capital account.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership To liquidate a partnership, follow these steps: 1. Sell noncash assets for cash and recognize any gain or loss on realization. 2. Allocate any gain or loss on realization to the partners based on their income ratios. 3. Pay partnership liabilities in cash. 4. Distribute remaining cash to partners based on their capital balances. The liquidation of a partnership terminates the business.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Capital Shortfall It is possible for a partner to have a negative (debit) balance in their Capital account when all of the liquidation transactions are completed. This could happen if: a partner starts the process with a low capital balance due to a series of losses, selling assets below book value, or a lot of drawings. If this happens, the partner(s) with the debit balance owes the businesses the amount of the shortfall.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership Capital Shortfall If this happens, the partner(s) with the debit balance owes the businesses the amount of the shortfall. In order for the other partners to collect their equity, the partner pays cash to the business and then the remaining partners can collect the full amount owing. If the shortfall is not paid, or cannot be paid, the remaining partners write off the amount that is owed, based on the income sharing ratio, by debiting their capital accounts and crediting the capital of the partner with a debit balance to bring it to a zero balance.

Establishing a Partnership Dividing Net Income (Loss) Adding a New Partner Withdrawal of a Partner Dissolution of the Partnership Equity Section of a Balance Sheet for a Partnership The main difference between the equity section of a partnership and the equity section of a sole proprietorship is that the equity position of all owners must be shown. The partners' equity section of a balance sheet would look like this: