Partnership

CHAPTER 11
 Partnerships

 “. . . 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.
Partnership Characteristics

 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 Characteristics
(continued…)

 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 Characteristics
(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 Characteristics
(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.
 Partnership Characteristics
(continued…)

 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.
Partnership Characteristics
(continued…)

 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.
 Partnership Advantages

 Advantages:
 Easy to form, change, and dissolve.
 Facilitates the pooling of capital,
resources and individual talents.
 No corporate tax.
 More flexibility than corporations.
Partnership Disadvantages

 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.
Other 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.
 Discussion

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.
1. Advantage
2. Disadvantage
3. Advantage
4. Disadvantage
Accounting for Partners’
Equity
 Owner’s equity is called partners’ equity.
 Must maintain separate accounts for
each partner.
Accounting for Partners’ Equity

 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.
Accounting for Partners’ Equity

 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

 Discussion

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. Non-cash assets are valued at fair market
value as of the date of investment. Thus,
Bob’s capital account would increase $1,000.
Distributing 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 Losses

 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 Losses

 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.
 Stated Ratios

 The partnership agreement would state in what ratio

partnership income is to be distributed to the partners.
 For example: Assume $20,000 is 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 Ratios

 The journal entry to show the distribution to

Bob and Joe would be:
Income Summary 20,000
Bob, Capital 15,000
Joe, Capital 5,000
Distribution of income for the year to partners’
Capital accounts
 Capital 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 Ratios

 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 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 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
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 Ratios

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 Income
Partner Distributed Joe Bob Total
income: $140,000
Dist. of Salaries:
Joe $8,000
Bob $7,000 (15,000)
Remaining income
after salaries $125,000
 Salaries, Interest, and Stated
Ratios
Step Two - Distribution of interest:
Income of Income Partner
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 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
Salaries, Interest, and Stated
Ratios
(continued…)

 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
Salaries, Interest, and Stated Ratios
(continued…)

 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.
 Discussion
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.
Dissolution 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 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
Partner

 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.
 Admission of a 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.
Admission of a New Partner

 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 Partner

 If Joe and Bob’s Capital accounts are $70,000

and $80,000, after Rosa’s investment the
partnership capital would be:
Joe $70,000
Bob 80,000
Rosa 75,000
Total $225,000

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

Admission of a New Partner
(continued…)

 The journal entry to record Rosa’s investment

would be:
Cash 75,000
Rosa, Capital 75,000
Admission of Rosa to a one-third interest in the
partnership
 Bonus 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

 When a bonus is due to the old partners, the

following journal entry would be made:
Cash XXX
Old Partner, Capital XXX
Old Partner, Capital XXX
New Partner, Capital XXX
 Bonus 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 Partner
(continued…)

 When a bonus is due the new partner, the

following journal entry would be made:
Cash XXX
Old Partner, Capital XXX
Old Partner, Capital XXX
New Partner, Capital XXX
 Discussion

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
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.
 Withdrawal 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 Partner
(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 Withdraw
 Withdrawal 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 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 Assets

 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 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.
 Discussion

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.
 Liquidation 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.
Liquidation of a Partnership
 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:
Gain 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: 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 Realization
To record sale of land and inventory
upon liquidation
 Cash balance is $66,000 ($20,000 + $46,000).
Liquidation of a Partnership: Example

 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 $20,500.
Liquidation of a Partnership: Example

 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 Assets
Example 1: Loss Absorbed by Capital Balance

 Assume that Joe and Bob partnership had

the following assets, liabilities, and equity:

Cash $20,000 Accounts Payable $5,000

Inventory 15,000 Joe, Capital 30,000
Land 10,000 Bob, Capital 10,000

 Assume that they share income and losses

equally.
Loss 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 Loss

 The loss is distributed to the partners’ Capital accounts

(equally in this example.)

Joe, Capital 1,500

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

To distribute realized loss.

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

 Bob’s Capital account is now $8,500.
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
Liquidation of a Partnership

 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.
 Discussion

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.
Next class

 Quiz
 Read chapter 14 ; long term liabilities
 Major quiz(5%) on chapter 9,10,11,14 after we
finish chapter 14.
 So start preparing