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

ACCOUNTING FOR PARTNERSHIPS CHAPTER 13

DEFINITION OF A PARTNERSHIP According to the Partnership Act 1961, a partnership is defined as the relationship that exists between individuals who carry out a business together with the purpose to make a profit.

PARTNERSHIP CHARACTERISTICS Unlimited Liability Partnership Form of Business Organization Association of Individuals Mutual Agency Co-ownership of Property Limited Life

ADVANTAGES AND DISADVANTAGES OF A PARTNERSHIP ADVANTAGES AND DISADVANTAGES OF A PARTNERSHIP

TYPES OF PARTNERSHIPS General Partner Has unlimited liability for the debts of the business and the right to make managerial decisions. Limited (or Silent) Partner Has the right to participate in the income of the business, but his/her liability for losses is limited to the amount of his/her investment. Can not actively participate in the management of the business. Investor rather than a traditional partner. Nominal Partner A person who has an interest in the success of a partnership firm and whose name lends credibility and recognition to the firm. Usually paid a fee for his/her service. Legally, the person is not a partner.

FORMING A PARTNERSHIP After a partnership has been formed, the accounting is similar to accounting for transactions of a sole proprietorship, except that separate capital and drawing accounts are maintained for each partner. 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. Upon the formation of a partnership, this personal computer should be recorded at its FMV of $2,500 instead of net book value.

CAPITAL ACCOUNTS Capital Accounts are opened for each partner to record the capital contributed when the partnership is formed. Capital contributed consists of cash or assets.

DIVIDING NET INCOME OR NET LOSS Partnership net income or net loss is shared equally unless the partnership contract specifically indicates otherwise. The same basis of division usually applies to both net income and net loss, and is called the income ratio or the profit and loss ratio. A partner’s share of net income or net loss is recognized in the accounts through closing entries.

CLOSING ENTRIES Four closing entries are required for a partnership: 1. Debit each revenue account for its balance and credit Income Summary for total revenues. 2. Credit each expense account for its balance and debit Income Summary for total expenses. 3. Debit (credit) Income Summary for its balance and credit (debit) each partner’s capital account for his or her share of net income (net loss). 4. Debit each partner’s capital account for the balance in that partner's drawing account and credit each partner’s drawing account for the same amount.

INCOME RATIOS The partnership agreement should specify the basis for sharing net income or net loss. 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.

INCOME STATEMENT WITH DIVISION OF NET INCOME Sara King and Ray Lee are partners in the Kingslee Company. The partnership agreement provides for 1) salary allowances of $8,400 for Sara and $6,000 for Ray, 2) interest allowances of 10% on capital balances at the beginning of the year, and 3) the remaining income to be split equally. Beginning Capital balances were King $28,000 and Lee $24,000. The division of the 2003 partnership income of $22,000 is as follows: 2,400 0 King Lee Total Total net income $22,000 Based on salary allowance Based on interest allowance: King - ($28,000 X 10%) Lee - ($24,000 X 10%) Total Remaining income Remainder shared equally Division of net income $8,400 $6,000(14,400) 2,800 2,400 (5,200) 1,200 1,200 (2,400) $12,400 $ 9,600$22,000

PARTNER’S CAPITAL STATEMENT The equity statement for a partnership is called the statement of partners' capital. It’s function is to explain the changes 1) in each partner’s capital account and 2) in total partnership capital during the year.

The statement of partners’ equity is prepared from the income statement and the partners’ capital and drawings accounts. The balance sheet for a partnership is the same as for a proprietorship except in the equity section. The capital balances of the partners are shown in the balance sheet. PARTNER’S EQUITY SECTION OF A PARTNERSHIP BALANCE SHEET

ADMISSION OF A PARTNER The admission of a new partner results in the legal dissolution of the existing partnership and the beginning of a new partnership. To recognize economic effects, it is necessary only to open a capital account for each new partner. 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.

PROCEDURES IN ADDING PARTNERS Admission of Partner through: I. Purchase of a Partner’s Interest Partnership Assets 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 or other consideration exchanged is the personal property of the participants and not the property of the partnership.

ADMISSION BY PURCHASE OF AN INTEREST E.g. Pam Lee sells her $80,000 equity interest in the partnership to Paul Trent for $100,000. The journal entry only records the $80,000 transfer of interest. Cash exchanged between Paul Trent and Pam Lee is a personal transaction.

PROCEDURES IN ADDING PARTNERS II. Investment of Assets in Partnership Hello Partnership Assets 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. Admission of Partner through:

BONUS TO OLD 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.

BONUS TO NEW PARTNER The procedure for determining the new partner’s capital credit and the bonus to the new partner 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 investment from the new partner’s capital credit. 4.Allocate the bonus from the old partners on the basis of their income ratios.

WITHDRAWAL OF A PARTNER A partner may withdraw from a partnership voluntarily by selling his or her equity in the firm or involuntarily by reaching a mandatory retirement age or by dying. The withdrawal of a partner may be accomplished by 1. payment from remaining partners’ personal assets or 2. payment from partnership assets.

PAYMENT FROM PARTNERS’ PERSONAL ASSETS The withdrawal of a partner when payment is made from partners’ personal assets is the direct opposite of admitting a new partner who purchases a partner’s interest. Withdrawal by payment from partners’ personal assets is a personal transaction between the partners. Bye Partnership Assets

BONUS TO RETIRING PARTNER A bonus may be paid to a retiring partner when: 1. the fair market value of partnership assets is greater than their book value, 2. there is unrecorded goodwill resulting from the partnership’s superior earnings record, or 3. the remaining partners are anxious to remove the partner from the firm. BONUS

BONUS TO RETIRING PARTNER The bonus is deducted from the remaining partners’ capital balances on the basis of their income ratios at the time of the withdrawal. The procedure for determining the bonus to the retiring partner and the allocation of the bonus to the remaining partners is: 1.Determine the amount of the bonus by subtracting the retiring partner’s capital balance from the cash paid by the partnership. 2.Allocate the bonus to the remaining partners on the basis of their income-sharing ratios.

BONUS TO REMAINING PARTNERS The retiring partner may pay a bonus to the remaining partners when: 1. recorded assets are overvalued, 2. the partnership has a poor earnings record, or 3. the partner is anxious to leave the partnership. BONUS

BONUS TO REMAINING PARTNERS The bonus is added to the remaining partners’capital balances on the basis of their income ratios at thetime of the withdrawal. The procedure for determining the bonus to the remaining partners is: 1.Determine the amount of the bonus by subtracting the retiring partner’s capital balance from the cash paid by the partnership. 2.Allocate the bonus to the remaining partners on the basis of their income ratios.

LIQUIDATION OF A PARTNERSHIP The liquidation of a partnership terminates the business. To liquidate a partnership, follow these steps: 1. Prepare financial statements and close out the accounts to determine an after-closing Balance Sheet 2. Sell noncash assets for cash and recognize any gain or loss on realization. 3. Allocate any gain or loss on realization to the partners based on their income ratios. 4. Pay partnership liabilities in cash. 5. Distribute remaining cash to partners based on their capital balances.

LIQUIDATION OF PARTNERSHIP No capital deficiency Distribute cash to the partners according to the balances in their capital accounts Capital deficiency Partner with deficiency pays partnership, or Partners with credit capital balances absorb the deficiency in income sharing proportion

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