CHAPTER 13 Partnership Form of Organization partnership act: rules of formation and operation: partnership: 2+ who do business with objective

= profit E.g. small retail + manufacturing companies, professionals (accounting, advertising, law, medicine) Characteristics of Partnerships Informal verbal agreement/formal writing rights + objectives. 1. Association of Individuals Voluntary association (agreement for partnership) Legal Entity: can own property in its name. Accounting Entity: for financial reporting purposes. Personal items excluded. Division of Income Division of net income/loss specified (if not, assumed equal) Each partners share is personally taxable (not together as an entity), recorded on partners personal income tax return + taxed at personal tax rate regardless of amount withdrawn from partnership. Mutual Agency Each partner acts for the partnership, actions are binding for all other partners even if they exceed authority (so long as act it is appropriate for partnership) Co-Ownership of Property Partnership assets owned jointly, even if dissolved, each partner has claim on total assets equal to balance in respective capital account (no rights to specific assets that each contributed) Limited Life Partnership dissolution: whenever a partner withdraws (involuntarily or voluntarily), any change in ownership. If continuing partners agree, operations can continue without interruption through forming new partnership. Unlimited Liability Each partner is jointly and severally (individually) liable for all partnership liabilities: creditors can claim personal resources of any partner if necessary.

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Organizations with Partnership Characteristics Modified partnership characteristics: 1. Limited Partnership General partner: one or more who have unlimited liability Limited partner: one or more with limited liability, responsible for debts limited to amount of capital contributed. Usually less compensation and influence. E.g. as income tax shelter or investment (Ltd. Or LP) Limited Liability Partnerships Some provinces do not allow professionals to incorporate + limit liability. LLP: protects innocent partners from negligence claims from acts of another partner (but responsible for their own) Multidisciplinary Practices MDPs: professional service organizations, lawyers as partners with accountants or other professionals (e.g. Ernst & Young: accounting, business advisory, law) Controversy: fear of conflict of interest and confidentiality: accountants have public disclosure obligations, lawyers bound by solicitor-client privilege. Ontario: controlled by lawyers + main business must be law

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Advantages and Disadvantages of Partnerships PRO: combines skills and resources, easily formed and relatively free from government regulations and restrictions, decisions made quickly on important matters (no board of directors). CON: mutual agency, limited life, unlimited liability (fear of losing initial investment, personal assets to pay partnership creditors hard to obtain large investment capital).

Partnership Agreement Written contract: basic information: name, principal location, purpose of business, date of inception. Relationships: 1. Names and capital contributions of partners 2. Rights and duties of partners 3. Basis for sharing net income or net loss 4. Provisions for withdrawal of assets 5. Procedures for submitting disputes to arbitration 6. Procedures for the withdrawal, or addition, of a partner 7. The rights and duties of surviving partners in the event of a partners death If it does not exist, provisions of Partnership Act apply. Contract anticipates situations, contingencies, disagreements. Basic Partnership Accounting Forming a Partnership Each partners initial investment is entered in partnership records at fair market value at date of transfer to partnership E.g: Book Value Market Value Gan Sin Gan Sin Cash $8000 $9,000 $8,000 $9,000 Office Equipment 5,000 4,000 Accumulated Amortization (2,000) Accounts Receivable 4,000 4,000 Allowance for Doubtful Accounts _______ (700) ______ (1,000) $11,000 $12,300 $12,000 $12,000 Investment of Gan: DR CASH 8,000, DR OFFICE EQUIPMENT 4,000, CR M. GAN, CAPITAL 2000. Investment of Sin: DR CASH 9000, DR ACCOUNTS RECEIVABLE 4000, CR ALLOWANCE FOR DOUBTFUL ACCOUNTS 1000, CR K. SIN, CAPITAL 12000. Equipment is recorded at fair market value (not book value, not original cost: no accumulated amortization as it hasnt been used yet) Gross claims on customers are carried over, allowance for doubtful accounts adjusted (partnership continues to collect existing A/R, also maintains relationship between AR control and AR subsidiary ledger) Minor differences in journalizing + posting closing entries and financial statements

Dividing Net Income or Net Loss Shared equally unless partnership agreement specifies otherwise Basis: income ratio (aka income and loss ratio, profit and loss ratio) : recognized in closing entries Closing Entries (1) DR each revenue account and CR Income Summary for total revenues (DR SALES REVENUE 100,000. CR INCOME SUMMARY 100,000) (2) DR Income Summary for total expenses and CR each expense account (DR INCOME SUMMARY 68,000. CR OPERATING EXPENSES 68,000.) (3) DR Income Summary for its balance (= net income) and CR each partners capital account for their share (or opposite dr cr for loss) (4) DR each partners capital account for balance in partners drawings account, CR each partners drawings account. Income Summary: easier to close numerous capital accounts summarizes net income/loss before allocating to each partner: temporary Income Ratios (1) Fixed ratio, proportion (2:1) or percentage, or fraction Easy, equitable in circumstances of same capital, different work schedules (2) Ratio based on either capital balances at the beginning or end of year, or on avg capital balances during year Appropriate when funds invested is critical factor; when a manager is hired and partners do not take active roles (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, as well as interest on partners capital balances, and the remainder in a fixed ratio. Specific recognition to differences among partners: provide salary allowance for time worked + interest allowance for capital invested. Remaining net income/loss allocated using fixed ratio Objective: to equitably reflect partners capital investment and service to partnership

Ratios divide net income/net loss (allocating to partners): not expenses. (not salaries expense as they are not employees, not interest expense as they are not employees/creditors). E.g. some partnership agreements allow monthly withdrawals based on salary allowance debited to partners drawings.

Salaries, Interest, and Remainder in a Fixed Ratio Salaries and interest allocated before remainder divided by fixed ratio (even if salary + interest > net income, or if net loss) E.g. (1) salary allowances of $8,400 to King and $6,000 to Lee, (2) interest allowances of 10% on capital balances at the beginning of the year, (3) remainder distributed equally. Net Income: KINGSLEE COMPANY Division of Net Income For the Year Ended December 31, 2003 Sara King Ray Lee Total Salary Allowance $8,400 $6,000 $14,400 Interest Allowance King ($28,000 x 10%) 2,800 Lee ($24,000 x 10%) 2,400 5,200 19,600 Remaining Income $22,000 = $19,600 = $2,400 King ($2,400 x 50%) 1,200 Lee ($2,400 x 50%) _____ 12,00 2,400 $12,400 $9,600 $22,000 Entry: DR INCOME SUMMARY 22,000, CR SARA KING, CAPITAL 12,400, CR RAY LEE, CAPITAL 9,600, To close net income to partners capital accounts Net Loss: divide up the salary, interest, use remaining deficiency and divide it with brackets Partnership Financial Statements Income Statement: identical. Allocation of partnership net income is often disclosed separate schedule/note Statement of Partners Capital: explains changes in capital account + total capital during year (from additional investments, drawings, each partners share of net income/loss) Prepared from income statement and partners capital and drawings accounts KINGSLEE COMPANY Statement of Partners Capital For the Year Ended December 31, 2003 Sara King Ray Lee Total Capital, January 1 $28,000 $24,000 $52,000 Add: Investments 2,000 0 2,000 Net Income 12,400 9,600 22,000 42,400 33,600 76,000 Less: Drawings 7,000 5,000 12,000 Capital, December 31 $35,400 $28,600 $64,000 Balance Sheet: difference in equity section: Partners Equity: KINGSLEE COMPANY Balance Sheet (Partial) December 31, 2003 Total Liabilities (assumed amount) $115,000 Partners Equity Sara King, Capital $35,400 Ray Lee, Capital 28,600 64,000 Total liabilities and partners equity $179,000 Admission and Withdrawal of Partners Admission of a Partner Legal dissolution of the existing partnership + beginning of a new one Minor significance: usually without any change, only opening a capital account for each new partner. (1) Purchasing interest of existing partner: transfer of capital among partners; total capital unaffected (2) Investing assets in the partnership: increases net assets (total assets total liabilities) and total capital

Purchase of a Partners Interest Admission by purchase of an interest: personal transaction between existing partners and new partner (each as individual, separate from partnership entity). Prices are negotiated. Purchase price: new partner other partner. Money is personal property, not of the partnership. Accounting: transfer of partners capital. Total assets, liabilities, capital unchanged. Regardless of amount paid for part of the interest, the entry will record only that part of the interest. DR NAME, CAPITAL 10,000, DR NAME, CAPITAL 10,000, CR NAME, CAPITAL 20,000. To record admission of NAME by purchase. Investment of Assets in a Partnership Admission by investment: transaction between new partner and partnership Increases net assets + total capital E.G. Carson invests $30,000 for 1/3 capital interest (remember 1/3 capital interest might not = 1/3 income ratio: should be specified in agreement) DR Cash 30,000. CR L. Carson, Capital 30,000. To record admission of Carson by investment.

Comparison Admission by Purchase of an Interest Admission by Investment Net Assets $60,000 Net Assets Capital Capital D. Arbour $20,000 D. Arbour D. Baker 20,000 D. Baker L. Carson 20,000 L. Carson Total Capital $60.000 Total Capital Complications when new partners investment differs from capital equity: Bonus to Old Partners Bonus to New Partner

$90,000 $30,000 30,000 30,000 $90,000

Withdrawal of a Partner Voluntarily (selling equity), Involuntarily (mandatory retirement, expulsion, dying): legally dissolves partnership. Customary to record only economic events: partnership reorganizes + continues Payment from Partners Personal Assets Personal transaction between partners, payment made from remaining partners personal assets (not involved, total capital doesnt change): transferring/re-allocation capitals balances E.G. One has $25,000, Two has $15,000, and Three has $10,000 = $50,000. One and Two buy out Threes interest. Each pays Three $8,000 in exchange for $10,000. Entry: DR Three, Capital 10,000. CR One, Capital 5,000. CR Two, Capital 5,000. To record purchase of Threes interest. One and Two will share net income/loss equally unless otherwise specified.

Payment from Partnership Assets Involves partnership: partnership net assets and total capital decreased Some partnership agreements: amount paid should be based on fair market value of assets at the time, differences should be (1) recorded by adjusting entry, (2) allocated to all partners on basis of income ratios. Flaws: violates cost principle, going concern assumption Asset revaluations should not be recorded: differences should be considered: Bonus to Departing Partner (1) Fair market value of partnership assets > net book value (2) Unrecorded goodwill resulting from partnerships superior earnings record (3) Remaining partners are anxious to remove partner from firm. Bonus deducted from remaining partners capital balances on basis of income ratios at time of withdrawal (1) Determine amount of bonus, (2) Allocate bonus to remaining partners on the basis of income ratios Remaining partners will recover bonus given as undervalued assets are used or sold Bonus to Remaining Partners (1) Recorded assets are overvalued. (2) The partnership has a poor earnings record (3) The partner is anxious to leave the partnership Cash paid to departing partner is less than their capital balance. Bonus allocated to capital accounts based on income ratios (credited) Liquidation of a Partnership

Terminates business legally and economically: selling assets, paying liabilities, distributing remains to partners From sale of business by mutual agreement, death of partner, or bankruptcy Accounting cycle completed prior: only balance sheet items open Realization: sale of noncash assets. Cash proceeds net book value: gain/loss

No Capital Deficiency (partners have credit balances) 1) Realization: Apr 18 Cash Accumulated Amortization Equipment Accounts Receivable Inventory Equipment Gain on Realization Gain on realization $15,000 allocated: (3:2:1) Gain on Realization R. Aube, Capital P. Chordia, Capital W. Elliot, Capital Partnership Liabilities paid Notes Payable Accounts Payable Cash Remaining cash distributed based on capital balances R. Aube, Capital P. Chordia, Capital W. Elliot, Capital Cash 22,50022,8003,70049,00015,00016,00031,00015,0007,5005,0002,50075,0008,00015,00018,00035,00015,000-

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4) Apr 25

Capital Deficiency (debit: from recurring net losses, excessive drawings, losses from realization) Apr18 Cash Accumulated Amortization Equipment Loss on Realization Accounts Receivable Inventory Equipment R. Aube, Capital P. Chordia, Capital W. Elliot, Capital Loss on Realization Notes Payable Accounts Payable Cash 42,0008,00018,00015,00018,00035,0009,0006,0003,00018,00015,00016,00031,000-

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Apr 23

Debit Balances: Cash $16,000 and W. Elliot, Capital $1,800 Payment of Deficency Cash W. Elliot, Capital Nonpayment of Deficiency

Apr 24

1,8001,800-

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R. Aube, Capital P. Chordia, Capital W. Elliot, Capital R. Aube, Capital P. Chordia, Capital Cash

1,0807201,800 6,00011,80017,800-

Apr 25

Homework BE13-1: a) b) c) d) e) f) g) h) BE13-2: Alfredo: 2003 July 10 Cash R. Alfredo, Capital To record investment of Alfredo. 15,00015,000-

Limited Liability Partnership General Partnership Income Ratio J D D F Partnership Liquidation

Panos: 2003 July 10 Cash Equipment B. Panos, Capital To record investment of B. Panos. 10,0006,00016,000-

BE13-3: