1. Chapter 19 Partnerships

2. Copyright © Houghton Mifflin Company. All rights reserved.19 | 2 General Partnership (GP) An association of two or more people or firms to carry on, as co-owners, a business for profit A voluntary association entered into by the partners

3. Copyright © Houghton Mifflin Company. All rights reserved.19 | 3 General Partners General partners actively and publicly participate in the transactions of the firm and have unlimited liability. Each party owns a fractional share of all the assets.

4. Copyright © Houghton Mifflin Company. All rights reserved.19 | 4 Unlimited Liability Each partner is personally liable to creditors for all the debts the partnership incurs during his or her membership in the firm. New partners may or may not assume liability for prior partnership debts. Partners who withdraw from a firm must give adequate public notice of withdrawal. –If he or she does not, he or she may be held liable for debts the partnership incurs after his or her withdrawal.

5. Copyright © Houghton Mifflin Company. All rights reserved.19 | 5 Limited Partnership (LP) An organization with two or more people or firms with at least one general partner and one limited partner General Partners May have little or no investment, organizes, manages, and controls operations Limited Partners Have largest share of invested capital, not involved in day-to-day operations, and usually cannot lose more than their capital contribution

6. Copyright © Houghton Mifflin Company. All rights reserved.19 | 6 Limited Liability Partnership (LLP) An organization similar to a limited partnership except that all partners may take an active role in the business with only their invested capital at risk © Royalty Free PhotoDisc/ Getty Images

7. Copyright © Houghton Mifflin Company. All rights reserved.19 | 7 Limited Life Partnerships have a limited life. Partnerships end as a result of: –The death or withdrawal of a partner –Bankruptcy –Expiration of the period of time specified in the partnership agreement –Completion of the project for which the partnership was formed

8. Copyright © Houghton Mifflin Company. All rights reserved.19 | 8 Mutual Agency Mutual agency is the ability of each partner to act as an agent of the firm, thereby committing the entire firm to a binding contract. Each partner can enter into binding contracts in the name of the firm for the purchase or sale of goods or services within the normal scope of the firm’s business.

9. Copyright © Houghton Mifflin Company. All rights reserved.19 | 9 Mutual Agency If the partners agree among themselves to limit the right of any partner to enter into certain contracts in the name of the firm: –This agreement is not binding on outsiders who are unaware of its existence. –If the partners want the limitation to become effective, they should notify their existing and potential customers.

10. Copyright © Houghton Mifflin Company. All rights reserved.19 | 10 Advantages of a Partnership 1.Opportunity to pool abilities and capital of people or firms 2.Easy to create (requires only a partnership agreement—written or oral) 3.Minimal legal restrictions (partnership must have a legal purpose) 4.No federal income taxes levied against a partnership as an entity, but the partnership must file an information form with the IRS (Form 1065) –The partners will report their distributed share of income on their individual return (whether or not this share is taken out of the business).

11. Copyright © Houghton Mifflin Company. All rights reserved.19 | 11 Disadvantages of a Partnership 1.Unlimited liability –General partners (who actively and publicly participate in transactions of the firm) are personally liable for all the partnership debts. 2.Limited life –Could also be an advantage 3.Mutual agency –Actions of one partner are binding on the other partners. –Could also be an advantage

12. Copyright © Houghton Mifflin Company. All rights reserved.19 | 12 Disadvantages of a Partnership (cont’d) 4.Difficulty of transferring a partial or entire partnership interest to another person –Such a transfer must be agreed to by all partners. 5.Difficulty of managing relationships with partners

13. Copyright © Houghton Mifflin Company. All rights reserved.19 | 13 Partnership Agreements Written contracts preferred over oral contracts Provisions usually included in written partnership agreements: –Effective date of the agreement –Names and addresses of the partners –Name, location, and nature of the business –Management structure –Duration of the agreement –Investment of each partner –Procedure for sharing profits and losses –Withdrawals to be allowed each partner –Procedure for a partner’s exit from the business –Provisions for division of assets upon liquidation

14. Copyright © Houghton Mifflin Company. All rights reserved.19 | 14 Partnership Accounting The only difference between accounting for a sole proprietorship and a partnership is the owners’ equity accounts: –Capital account for each partner –Drawing account for each partner

15. Copyright © Houghton Mifflin Company. All rights reserved.19 | 15 Recording Investments Record separate journal entries for the investment of each partner. –When a partner’s contributed assets are greater than the partner’s assumed liabilities, credit the partner’s Capital account. Investments of partners may include cash and other assets, along with related liabilities.

16. Copyright © Houghton Mifflin Company. All rights reserved.19 | 16 Recording Initial Investments: An Example On February 2, Rita and Ralph agree to form a partnership to operate a jewelry store. Rita invests cash.

17. Copyright © Houghton Mifflin Company. All rights reserved.19 | 17 Recording Initial Investments: An Example (cont’d) Ralph contributes the existing assets and liabilities from a prior business: Cash $ 2,900 Accounts Receivable 18,000 Allowance for Doubtful Accounts 200 Merchandise Inventory 180,400 Equipment 16,000 Accumulated Depreciation, Equipment 4,500 Notes Payable 1,600 Accounts Payable 8,400

18. Copyright © Houghton Mifflin Company. All rights reserved.19 | 18 Recording Contributed Assets and Liabilities 1.Determination of the value of the noncash assets (inventory, equipment) required 2.May require revaluation by an independent appraiser 3.New aging of accounts receivable required

19. Copyright © Houghton Mifflin Company. All rights reserved.19 | 19 Recording Revalued Assets and Liabilities

20. Copyright © Houghton Mifflin Company. All rights reserved.19 | 20 Additional Investments by the Partners Each partner invests an additional $7,000.

21. Copyright © Houghton Mifflin Company. All rights reserved.19 | 21 Partners’ Capital Accounts

22. Copyright © Houghton Mifflin Company. All rights reserved.19 | 22 Partners’ Withdrawals Withdrawal of $4,620 by Ralph H. Fox, $3,742 by Rita L. Lang.

23. Copyright © Houghton Mifflin Company. All rights reserved.19 | 23 Distributive Share A distributive share is the share of the net income (or net loss) allocated to each partner. The allocation of net income or loss may be reported as a separate statement or shown at the bottom of the income statement below net income.

24. Copyright © Houghton Mifflin Company. All rights reserved.19 | 24 Methods for Dividing Net Income/Loss Between Partners 1.Fractional shares 2.Ratio of capital investments 3.Salary allowances 4.Interest allowances If the partnership agreement fails to state a specific method of division, from a legal standpoint, the partners should share any net income or loss equally.

25. Copyright © Houghton Mifflin Company. All rights reserved.19 | 25 Division of Net Income/Loss for a Partnership: Two Examples A net income of $248,000 A net loss of $4,000 © Royalty Free PhotoDisc Blue/ Getty Images

26. Copyright © Houghton Mifflin Company. All rights reserved.19 | 26 Balances in the Capital and Drawing Accounts Using this example, we will look at each of the four methods of division of net income or loss.

27. Copyright © Houghton Mifflin Company. All rights reserved.19 | 27 Fractional Shares Method The agreement states that the two partners will divide the net income or loss in fractional shares of ¾ and ¼. © Royalty Free PhotoDisc Blue/ Getty Images

28. Copyright © Houghton Mifflin Company. All rights reserved.19 | 28 Calculating Fractional Shares Multiply net income or loss by each partner’s fraction as stated in the agreement. –For ratio listings, convert ratios to fractional shares as shown in the example below.

29. Copyright © Houghton Mifflin Company. All rights reserved.19 | 29 Division of Net Income of $248,000

30. Copyright © Houghton Mifflin Company. All rights reserved.19 | 30 T Accounts with Steps 3 and 4 Labeled

31. Copyright © Houghton Mifflin Company. All rights reserved.19 | 31 Division of Net Loss of $4,000

32. Copyright © Houghton Mifflin Company. All rights reserved.19 | 32 Ratio of Capital Investments Method Multiply net income or loss by a fraction with the partner’s beginning Capital balance in the numerator and the total of partners’ Capital balances in the denominator. This method is appropriate for businesses whose earnings are closely related to the amount of money invested: –Real estate ventures –Cattle feeding operations

33. Copyright © Houghton Mifflin Company. All rights reserved.19 | 33 Calculating the Ratio of Capital Investment Bell $300,000 Campbell 75,000 Total $375,000 Bell’s share $300,000 / $375,000 =.80 Campbell’s share $75,000 / $375,000 =.20 Bell’s share of earnings $248,000 ×.80 = $198,400 Campbell’s share of earnings $248,000 ×.20 = $49,600

34. Copyright © Houghton Mifflin Company. All rights reserved.19 | 34 Division of Net Loss of $4,000 Bell’s share of the loss $4,000 ×.80 = $3,200 Campbell’s share of the loss $4,000 ×.20 = $800

35. Copyright © Houghton Mifflin Company. All rights reserved.19 | 35 Salary Allowances Allocations of net income –A means of recognizing and rewarding differences in ability and in the amount of time devoted to the business –Guaranteed amounts determined without regard to the income of the partnership Not payments to partners –Withdrawals are recorded in Drawing accounts

36. Copyright © Houghton Mifflin Company. All rights reserved.19 | 36 Salary Allowances (cont’d) Not payments to employees –Payments to employees are recorded as Wages or Salaries Expenses Included in the division of net income/loss section of the income statement

37. Copyright © Houghton Mifflin Company. All rights reserved.19 | 37 Salary Allowance Method Deduct the amounts of salary allowances from the net income (or add them to the net loss) and divide the remainder by specified shares (usually equally). Assume the two yearly salary allowances are: –$60,000 –$40,000

38. Copyright © Houghton Mifflin Company. All rights reserved.19 | 38 Division of Net Income of $248,000 Net income $248,000 Less allocated as salaries ($60,000 + $40,000) 100,000 Remainder $148,000 Remainder / 2 = $148,000 / 2 = $74,000

39. Copyright © Houghton Mifflin Company. All rights reserved.19 | 39 Division of Net Income on the Income Statement

40. Copyright © Houghton Mifflin Company. All rights reserved.19 | 40 Division of Net Loss of $4,000 Net loss $ (4,000) Less salary allowances ($60,000 + $40,000) 100,000 Remainder $(104,000) Remainder / 2 = $(104,000 / 2 = $(52,000)

41. Copyright © Houghton Mifflin Company. All rights reserved.19 | 41 Division of Loss on the Income Statement

42. Copyright © Houghton Mifflin Company. All rights reserved.19 | 42 Interest Allowances Allocations of net income –Guaranteed amounts determined without regard to the income of the partnership –Act as an incentive to make capital investments Not interest expense

43. Copyright © Houghton Mifflin Company. All rights reserved.19 | 43 Calculating the Interest Allowance 1.Multiply allotted interest rate by partner’s capital investment. 2.Deduct the amounts of interest allowances from the net income (or add them to the net loss) and divide the remainder by specified shares (usually equally). For our continuing example, let’s assume the interest rate is 6 percent.

44. Copyright © Houghton Mifflin Company. All rights reserved.19 | 44 Division of Net Income Based on Interest Allowances Interest allowance for Bell: Capital Balance × Interest Rate $300,000 ×.06 = $18,000 Interest allowance for Campbell: Capital Balance × Interest Rate $75,000 ×.06 = $4,500

45. Copyright © Houghton Mifflin Company. All rights reserved.19 | 45 Division of Net Income Based on Interest Allowances (cont’d) Net income $248,000 Less: Salary allowance $60,000 + $40,000 $100,000 Interest allowances $18,000 + $4,500 22,500 122,500 Remainder $125,500 Remainder / 2 = $125,500 / 2 = $62,750

46. Copyright © Houghton Mifflin Company. All rights reserved.19 | 46 Division of Net Income of $248,000

47. Copyright © Houghton Mifflin Company. All rights reserved.19 | 47 Division of Net Loss of $4,000

48. Copyright © Houghton Mifflin Company. All rights reserved.19 | 48 Division of Loss Based on Interest Allowances Net loss $( 4,000) Less: Salary allowances $60,000 + $40,000 $(100,000) Interest allowances $18,000 + $4,500 (22,500) (122,500) Remainder $(126,500) Remainder / 2 = $(126,500) / 2 = $(63,250)

49. Copyright © Houghton Mifflin Company. All rights reserved.19 | 49 Entry to Close Net Income into Capital

50. Copyright © Houghton Mifflin Company. All rights reserved.19 | 50 Entry to Close the Drawing Accounts into the Capital Accounts

51. Copyright © Houghton Mifflin Company. All rights reserved.19 | 51 Closing Entries

52. Copyright © Houghton Mifflin Company. All rights reserved.19 | 52

53. Copyright © Houghton Mifflin Company. All rights reserved.19 | 53 Statement of Partners’ Equity Format is the same as that for a statement of owner’s equity. Use a Total column to record the combined total for each line. List additional investments (after beginning of period) directly below the beginning Capital balance. Use one column per partner to record each partner’s: –Beginning capital –Additional investment –Share of net income –Withdrawals –Ending capital

54. Copyright © Houghton Mifflin Company. All rights reserved.19 | 54 Statement of Partners’ Equity: An Example

55. Copyright © Houghton Mifflin Company. All rights reserved.19 | 55 Dissolution Dissolution is the ending of a partnership because of a change in the personnel of the membership and the forming of a new partnership. –One partnership ends and a new one begins. The transition results primarily in changes in the Capital accounts, with routine business being carried on as usual. Any change in the composition of partners results in a dissolution of the partnership.

56. Copyright © Houghton Mifflin Company. All rights reserved.19 | 56 Recording the Sale of a Partnership Interest Debit the Capital account of the old partner. Credit the Capital account of the new partner. © Royalty Free C Squared Studios/ Getty Images

57. Copyright © Houghton Mifflin Company. All rights reserved.19 | 57 Sale of Partnership Interest If a retiring partner sells his or her interest (Capital balance of $163,520) for $182,000, the partner pockets the profit and the partnership records an entry as follows:

58. Copyright © Houghton Mifflin Company. All rights reserved.19 | 58 Withdrawal of a Partner The partnership agreement should outline the procedures for withdrawal, requiring: –An audit of the books –A revaluation of the assets to reflect their market value A loss or gain on revaluation is shared according to the ratio agreed upon in the partnership agreement. An example of a partner withdrawing the book value of his or her equity after revaluation follows.

59. Copyright © Houghton Mifflin Company. All rights reserved.19 | 59 Journal Entry to Reflect the Loss to Partners After Revaluation

60. Copyright © Houghton Mifflin Company. All rights reserved.19 | 60 Updated Capital Accounts

61. Copyright © Houghton Mifflin Company. All rights reserved.19 | 61 Recording the Journal Entry to Reflect Withdrawal of Partner

62. Copyright © Houghton Mifflin Company. All rights reserved.19 | 62 Partner Withdraws More Than Book Value of His or Her Equity Sometimes a partner withdraws more cash than the amount of his or her Capital account. Possible reasons: –The business is prosperous and shows excellent potential for growth. –The remaining partners may want to provide an incentive for the partner to withdraw.

63. Copyright © Houghton Mifflin Company. All rights reserved.19 | 63 Partner Withdraws, Receiving More Than Book Value of His or Her Equity At the end of the given year, if the remaining partners paid $1,000 more than the book value of the withdrawing partner, the journal entry would look like this:

64. Copyright © Houghton Mifflin Company. All rights reserved.19 | 64 Partner Withdraws, Receiving Less Than Book Value of His or Her Equity At the end of the given year, if the remaining partners paid $4,200 less than the book value of the withdrawing partner, the journal entry would look like this:

65. Copyright © Houghton Mifflin Company. All rights reserved.19 | 65 Death of a Partner Death automatically ends the partnership. Books must be closed to determine the net income or loss. The death of a partner usually calls for an audit and a revaluation of the firm’s assets. The partner’s estate is entitled to receive the amount of his or her equity. The remaining partners and the executor of the estate determine the form of payment.

66. Copyright © Houghton Mifflin Company. All rights reserved.19 | 66 Definitions Liquidation –The ending of a partnership and the business itself Sale of the assets Payment of the liabilities Distribution of the remaining cash to the partners –Remember: Creditors are paid before partners! Realization –Conversion into cash, as happens with the sale of assets

67. Copyright © Houghton Mifflin Company. All rights reserved.19 | 67 New Account: Loss or Gain from Realization Used when there is a gain or loss from realization Has DR and CR, but no “+” or “-” Similar to: –Cash Short and Over –Income Summary

68. Copyright © Houghton Mifflin Company. All rights reserved.19 | 68 Journalize Entries for Each Step of the Liquidation Process 1.For the sale of the assets: –Debit Cash. –Credit the assets. –Record the difference in Loss or Gain from Realization. 2.Close Loss or Gain from Realization into the partners’ Capital accounts according to the partners’ agreed-on profit and loss ratio. 3.Pay off the liabilities. 4.Distribute the remaining cash according to the partners’ Capital account balances.

69. Copyright © Houghton Mifflin Company. All rights reserved.19 | 69 Simplified Example of Liquidation We will look at a partnership with three partners: –The fractional shares that the partners use for division of net income or loss (and liquidation) are as follows: ½, ¼, ¼ We will look at the balance sheet before the sale of assets and settlement of liabilities during the liquidation. Then we will look at the journal entries during liquidation and the resulting T accounts.

70. Copyright © Houghton Mifflin Company. All rights reserved.19 | 70 Balance Sheet Before the Sale of Assets

71. Copyright © Houghton Mifflin Company. All rights reserved.19 | 71 Journal Entries to Record Sale of Assets

72. Copyright © Houghton Mifflin Company. All rights reserved.19 | 72 Journal Entries to Record Settlement of Liabilities and Distribution of Cash

73. Copyright © Houghton Mifflin Company. All rights reserved.19 | 73 Cash and Capital Accounts After Liquidation

74. Copyright © Houghton Mifflin Company. All rights reserved.19 | 74 Journal Entries to Record Sale of Assets at a Loss

75. Copyright © Houghton Mifflin Company. All rights reserved.19 | 75 Entries to Record Settlement of Liabilities and Distribution of Cash

76. Copyright © Houghton Mifflin Company. All rights reserved.19 | 76 Cash and Capital Accounts After Liquidation

77. Copyright © Houghton Mifflin Company. All rights reserved.19 | 77 Closing Entries

78. Copyright © Houghton Mifflin Company. All rights reserved.19 | 78 Closing Entries