Copyright © by Houghton Miffin Company. All rights reserved.1 Principles of Financial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson

Copyright © by Houghton Miffin Company. All rights reserved. 1

Principles of Financial Principles of Financial Accounting 2002eAccounting 2002e

Belverd E. Needles, Jr.Belverd E. Needles, Jr.Marian PowersMarian PowersSusan CrossonSusan Crosson

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Harry Hooper Santa Fe Community College

Chapter 13Chapter 13PartnershipsPartnerships


LEARNING OBJECTIVESLEARNING 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. 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 LEARNING OBJECTIVES (continued…)(continued…)

OBJECTIVE 1

Identify the principal characteristics,

advantages, and disadvantages of the

partnership form of business.

Partnership CharacteristicsPartnership Characteristics


“. . . an association of two or more persons to carry on as co-owners of a business for profit.”

Partnerships are treated as separate accounting entities.

PartnershipsPartnerships


A partnership is a voluntary

association of individuals rather

than a legal entity in itself.

A partner has unlimited liability

for the debts of the partnership.

Partnership CharacteristicsPartnership Characteristics


A partnership is formed via a partnership agreement. The agreement specifies:

The name, location and purpose of the business The partners and their duties The investments of each partner The methods for distributing income and losses The procedures for the admission and withdrawal of

partners. The withdrawal of assets allowed each partner. The liquidation of the business

Partnership CharacteristicsPartnership Characteristics(continued…)(continued…)


A partnership has a limited life. A partnership is dissolved when:

A new partner is admitted. A partner withdraws. A partner goes bankrupt. A partner is incapacitated. A partner retires. A partner dies. The partnership ends per the partnership

agreement.

Partnership CharacteristicsPartnership Characteristics((continued…)continued…)


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.



Unlimited liability. All partners have unlimited liability for the

partnership’s debt. Creditors may seek payment from the personal

assets of each partner.

Co-ownership of partnership property. The property of a partnership is an asset of the

partnership and is owned jointly by all partners.



Participation in partnership income. Each partner has the right to share in the

company’s income and the responsibility to share in its losses.

The partnership agreement should state the method of distributing income and losses to each partner.

If the partnership agreement fails to detail how income and losses should be distributed, then they are distributed equally.



Advantages: Easy to form, change, and dissolve.

Facilitates the pooling of capital,

resources and individual talents.

No corporate tax.

More flexibility than corporations.

Partnership AdvantagesPartnership Advantages


Disadvantages: Limited life.

One partner can bind the partnership to a

contract.

Unlimited personal liability.

Lack of transferability of ownership.

Difficult to raise large amounts of capital.

Partnership DisadvantagesPartnership Disadvantages


Other Forms of AssociationOther Forms of Association

Limited Partnerships: Limited partner’s liability limited to the

amount of his or her investment. One general partner with unlimited liability.

Joint Ventures: Alliances between companies to achieve a

specific goal, often international. May have agreed-upon limited life. Partners may include governments.


DiscussionDiscussion

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.


A.A.

1. Advantage

2. Disadvantage

3. Advantage

4. Disadvantage

OBJECTIVE 2

Record partners’ investments of

cash and other assets when a

partnership is formed.

Accounting for Partners’ EquityAccounting for Partners’ Equity


Accounting for Partners’ EquityAccounting for Partners’ Equity(continued…)(continued…)

Owner’s equity is called partners’

equity.

Must maintain separate accounts for

each partner.



Each partner invests cash or other assets or a combination of the two in accordance with the partnership agreement. Noncash assets are valued at their fair market

value on the date of transfer to the partnership.

Invested assets are debited to the proper account and the partner’s capital account is credited for the total amount.



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: Cash 5,000

Truck 10,000

Joe, Capital 10,000

Bob, Capital 5,000

To record the initial investment



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.

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 Distribution of Partnership Income and LossesIncome and Losses


Distributing Income and LossesDistributing Income and Losses

Distribution method is typically detailed

in partnership agreement.

If partnership agreement is silent then

income/losses are shared equally.

If agreement only details income

distribution, losses are distributed in

the same ratio.


Distributing Income and LossesDistributing Income and Losses(continued…)(continued…)

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.


Distributing Income and LossesDistributing Income and Losses(continued…)(continued…)

Several ways may be used for partners to

share income are: Stated ratios.

Capital balance ratios.

Salaries and interest then remainder based on

stated ratios. Salaries and interest are not expenses to the

partnership.


Stated RatiosStated Ratios The partnership agreement would state in what

ratio partnership income is to be distributed to

the partners.

For example: Assume $20,000 in income and Bob

and Joe’s stated ratios are 75% and 25%,

respectively.

Computation of income distribution:

Bob (75% x $20,000) $15,000

Joe (25% x $20,000) 5,000

$20,000


Stated RatiosStated Ratios

The journal entry to show the distribution

to Bob and Joe would be:

Income Summary 20,000

Bob, Capital 15,000

Joe, Capital 5,000Distribution of income for the year to partners’ Capital accounts


Capital Balance RatiosCapital Balance Ratios

If invested capital produces the most income for the partnership, then income and losses may be distributed according to capital balance.

The ratio may be based on either: Beginning capital balance. Average capital balance.


Capital Balance RatiosCapital Balance Ratios(continued…)(continued…)

Assume that Bob and Joe had beginning capital balances of

$70,000 and $30,000, respectively.

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


Capital Balance RatiosCapital Balance Ratios 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.

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.


Capital Balance RatiosCapital Balance Ratios

Assume that Bob and Joe had average capital balances of

$60,000 and $20,000, respectively, and the average total

capital is $80,000.

If they distribute income based on average capital ratios,

the $20,000 income would be distributed:

Bob 60,000 ÷ 80,000 = 75% x 20,000 = $15,000

Joe 20,000 ÷ 80,000 = 25% x 20,000 = 5,000

$20,000


Salaries, Interest, and Stated RatiosSalaries, Interest, and Stated Ratios Partners generally do not contribute equally

to a firm. 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.

Remember partners’ “salaries and interest” are not an expense but rather a method of distribution of income or loss.


Salaries, Interest, and Stated RatiosSalaries, Interest, and Stated Ratios(continued…)(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 IncomePartner Distributed Joe BobTotal income: $140,000

Dist. of Salaries: Joe $8,000 Bob $7,000 (15,000)Remaining income

after salaries $125,000


Salaries, Interest, and Stated RatiosSalaries, Interest, and Stated Ratios

Step Two - Distribution of interest:

Income of IncomePartner

Distributed

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


Salaries, Interest, and Stated RatiosSalaries, Interest, and Stated Ratios

Step Three - Distribution of remainder:

Income of Income

Partners

Distributed

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



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



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.

After such allocation the “deficit” will be shared equally.



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.

OBJECTIVE 4

Record a person’s admission

to a partnership.

Dissolution of a PartnershipDissolution of a Partnership


Dissolution of a PartnershipDissolution 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:

Act for the partnership in finishing its affairs.

Form a new partnership.


Admission of a New PartnerAdmission of a New Partner

The admission of a new partner dissolves the old partnership.

A partner may be admitted in one of two ways.

1. Purchasing an interest from an original partner.

2. Investing assets in the partnership.


Purchasing an Interest From a Purchasing an Interest From a PartnerPartner

Each partner must agree to the change. The transaction is a personal transaction

between the old and new partners. The interest purchased must be transferred

from the Capital account of the old partner to the capital account of the new partner.



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 the old partner is a personal matter and not entered into the partnership’s books.



If a new partner is admitted by investing assets in the partnership, both the assets and the partners’ equity in the firm increase.

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.


Admission of a New PartnerAdmission of a New Partner If Joe and Bob’s Capital accounts are

$70,000 and $80,000, after Rosa’s investment the partnership capital would be:

Joe $70,000Bob 80,000Rosa 75,000Total $225,000

One-third interest = $225,000 ÷ 3 = $75,000


Admission of a New PartnerAdmission of a New Partner(continued…)(continued…)

The journal entry to record Rosa’s investment would be:

Cash 75,000

Rosa, Capital 75,000Admission of Rosa to a one-third

interest in the partnership


Bonus to the Old PartnersBonus to the Old Partners

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.

In this situation a “bonus” will result to the old partners.

This “bonus” should be distributed according to the terms of the partnership agreement.


Bonus to the Old Partners Bonus to the Old Partners

When a bonus is due the old partners, the following journal entry would be made:

Cash XXX

Old Partner, Capital XXX


New Partner, Capital XXX


Bonus to the New PartnerBonus to the New Partner

In some cases the partners may admit a new partner and transfer part of their existing Capital balances to the new partner.

In this situation a “bonus” will result to the new partner.

This “bonus” should be absorbed by the old partners according to the terms of the partnership agreement.


Bonus to the New PartnerBonus to the New Partner(continued…)(continued…)

When a bonus is due the new partner, the following journal entry would be made:

Cash XXX



New Partner, Capital XXX



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?


A.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.

OBJECTIVE 5

Record a person’s withdrawal

from a partnership.

Withdrawal of a PartnerWithdrawal of a Partner


Withdrawal of a PartnerWithdrawal of a Partner

When a partner decides to withdraw there are a number of considerations that should be spelled out in the partnership agreement.

Will an audit be performed? How will the assets be reappraised? How will a bonus be determined? How will the withdrawing partner be paid?


Withdrawal of a PartnerWithdrawal of a Partner(continued…)(continued…)

There are different ways a partner may withdraw. Sell his or her interest to another partner(s)

with the other partner(s)’ consent.

Sell his or her interest to an outsider with the

consent of the other partner(s).

Withdraw assets equal to, less than, or greater

than his or her capital balance.


Alternative Ways for a Partner to WithdrawAlternative Ways for a Partner to Withdraw


Withdrawal by Selling InterestWithdrawal by Selling Interest

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.

The balance in the selling partner’s Capital account is transferred to the new partner.


Withdrawal by Removing AssetsWithdrawal by Removing Assets Debit the withdrawal partner’s capital account to give

it a zero balance.

Credit the partnership’s asset accounts (e.g. Cash) for

the amount of assets removed.

Credit a promissory note payable to the withdrawing

partners for any excess of the capital account over

assets removed, if any.

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.


Withdrawal by Removing AssetsWithdrawal by Removing Assets(continued…)(continued…)

Example: Assume Rosa withdraws from the partnership when her Capital account has a balance of $60,000 and receives $40,000 cash.

In this situation Rosa is receiving less assets than her interest.

The equity she leaves ($20,000) is divided among the remaining partners according to their stated ratios.


Death of a PartnerDeath of a Partner When a partner dies, the partnership is dissolved

because the original association has changed. The partnership agreement should detail the steps to

be taken upon death. Normally, the books are closed and financial

statements are prepared. The remaining partners may purchase the deceased

partner’s equity, sell it to outsiders, or transfer assets to the estate.

If the firm will continue, a new partnership must be formed.



Q.What are the different ways a partner could withdraw from a partnership?

A.There are different ways a partner may withdraw: Sell his or her interest to another partner(s)

with the other partner(s)’ consent. Sell his or her interest to an outsider with the

consent of the other partner(s). Withdraw assets equal to, less than, or greater

than his or her capital balance.

OBJECTIVE 6

Compute the distribution of

assets to partners when they

liquidate their partnership.

Liquidation of a PartnershipLiquidation of a Partnership



Liquidation includes: Ending the business. Selling enough assets to pay the partnership’s

liabilities. Distributing any remaining assets among the

partners.

The partnership agreement should indicate the procedures to be followed.



As the assets are sold, any gain or loss is distributed to the partners according to the stated ratios.

As cash becomes available, it is applied: First, to partnership creditors (if any). Second, to partners’ loans (if any). Finally, to the partners’ capital balances.


Liquidation of a Partnership:Liquidation of a Partnership:Gain on Sale of AssetsGain on Sale of Assets

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 Assume that they share income and losses equally.


Liquidation of a Partnership: ExampleLiquidation of a Partnership: Example

Assume they sell the inventory for $32,000 and the land for $14,000.

Cash 46,000 Land 10,000 Inventory 15,000 Gain or Loss 21,000

from RealizationTo record sale of land and inventory upon liquidation

Cash balance is $66,000 ($20,000 + $46,000).


Liquidation of a Partnership: ExampleLiquidation of a Partnership: Example(continued…)(continued…)

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, Capital 10,500

Bob, Capital 10,500

Joe’s Capital account is now $40,500.

Bob’s Capital account is now $20,000.


Liquidation of a Partnership:ExampleLiquidation of a Partnership:Example(continued…)(continued…)

The Accounts Payable are now paid off at their book value:

Accounts Payable 5,000

Cash 5,000 The Cash account now has $61,000 which is equal

to the partners’ equity, $40,500 + $20,500

(Assets = Liabilities + Partners’ Equity). The cash is now distributed to Joe and Bob based

upon their Capital account balances.


Loss on Sale of AssetsLoss on Sale of AssetsExample 1: Loss Absorbed by Capital BalanceExample 1: Loss Absorbed by Capital Balance

Assume the Joe and Bob partnership had the following assets, liabilities, and equity:

Cash $20,000 Accounts Payable $5,000 Inventory 15,000 Joe, Capital 30,000Land 10,000 Bob, Capital 10,000

Assume that they share income and losses equally.


Loss on Sale of AssetsLoss on Sale of Assets

Assume the inventory is sold for $14,000 and the land for $8,000.

Cash 22,000

Gain or Loss 3,000

from Realization

Land 10,000

Inventory 15,000

To record sale of assets upon liquidation

Cash balance is now $42,000.


Distribution of LossDistribution of Loss The loss is distributed to the partners’ Capital

accounts (equally in this example.)

Joe, Capital 1,500Bob, Capital 1,500Gain or Loss 3,000from Realization

To distribute realized loss.

Joe’s Capital account is now $28,500. Bob’s Capital account is now $8,500.


Payment of Liabilities Payment of Liabilities The Accounts Payable are now paid off at

Book Value:

Accounts Payable 5,000

Cash 5,000

Cash balance is how $37,000 which is equal to the partner equity:

$28,500 + $8,500



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.

If the partner is unable to make up the deficit, then the remaining partners must share the loss based on their stated ratios.



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.


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…OK, LET’S REVIEW…


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…AND ALSO…

Documents

Copyright © by Houghton Miffin Company. All rights reserved.1 Principles of Financial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson