Prepared by: Keri Norrie, Camosun College ACCOUNTING PRINCIPLES Third Canadian Edition Prepared by: Keri Norrie, Camosun College

ACCOUNTING FOR PARTNERSHIPS CHAPTER 12 ACCOUNTING FOR PARTNERSHIPS

PARTNERSHIP CHARACTERISTICS (ILLUSTRATION 12-1) Association of Individuals Mutual Agency Co-ownership of Property Limited Life Partnership Form of Business Organization Unlimited Liability

ADVANTAGES AND DISADVANTAGES OF A PARTNERSHIP (ILLUSTRATION 12-2)

FORMING A PARTNERSHIP 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 After the partnership has been formed, the accounting is similar to accounting for transactions of any other type of business organization Upon the formation of a partnership, this personal computer should be recorded at its FMV of $2,500 instead of net book value

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 FOR PARTNERSHIPS (INDIVIDUAL) (INDIVIDUAL) EXPENSES 1 REVENUES 2 Normal Dr. Balance Normal Cr. Balance Cr. to close Dr. to close - 0 - - 0 - 1. Debit each revenue account for its balance, and credit the income summary account for total revenues. 2. Debit the income summary account for total expenses, and credit each expense account for its balance. Dr. Expenses Cr. Revenues Credit each partner’s capital account for his or her share of the net income. In addition, each partner’s capital account would also be debited for the balance in that partner’s drawings account. Dr. to close Cr. Balance = Net Income - 0 - 3 Opening Balance % Share of Net Income Opening Balance % Share of Net Income

INCOME RATIOS The partnership agreement should specify the basis for sharing net income or net loss. The basis should reflect the partners’ capital investment and service to the partnership. 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 or end 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.

DIVISION OF NET INCOME (ILLUSTRATION 12-3) Sara King and Ray Lee are partners in the Kingslee Company. The partnership agreement provides for: salary allowances of $8,400 for King and $6,000 for Lee interest allowances of 10% on capital balances at the beginning of the year, and the remainder to be distributed equally Capital balances on January 1 were King $28,000 and Lee $24,000 For the year ended December 31, 2005, partnership net income is $22,000

DIVISION OF NET INCOME (ILLUSTRATION 12-3) The division of net income for the year ended December 31, 2005 is as follows: King Lee Total Total net income $22,000 Salary allowance $8,400 $6,000 (14,400) Remaining income 7,600 Interest allowance: King - ($28,000 X 10%) 2,800 Lee - ($24,000 X 10%) 2,400 (5,200) 1,200 (2,400) Remainder shared equally Division of net income $12,400 $9,600

STATEMENT OF PARTNER’S CAPITAL (ILLUSTRATION 12-5) The equity statement for a partnership is the statement of partners' capital It’s function is to explain the changes in 1) each partner’s capital account and 2) total partnership capital during the year KINGSLEE COMPANY Statement of Partner’s Capital Year Ended December 31, 2005 Sara King Ray Lee Total Capital, January 1 28,000 24,000 52,200 Add: Investments 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 – Partial PARTNER’S EQUITY SECTION OF A PARTNERSHIP BALANCE SHEET (ILLUSTRATION 12-6) 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 each partner are shown in the balance sheet KINGSLEE COMPANY Balance Sheet – Partial December 31, 2005 Total liabilities (assumed amount) $115,000 Partners’ equity Sara King, Capital $35,400 Ray Lee, Capital 28,600 Total partners’ equity 64,000 Total liabilities and partners’ equity $179,000 20

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. A new partner may be admitted either by: Purchasing the interest of one or more existing partners, or Investing assets in the partnership

Purchase of a Partner’s Interest ADMISSION OF A PARTNER Purchase of a Partner’s Interest The Partnership’s Accounting Equation: Assets Liabilities Partners’ Equity = + In a purchase of an interest from existing partners, it is a personal transaction between one or more existing partners and the new partner The amount paid does not affect the partnership’s accounting equation; the cash is received personally by the existing partners involved In the partnership, the only effect is that the existing partners’ equity is decreased by the amount of equity given to the new partner while the new partner’s equity is increased by that amount New partners’ equity Existing partners’ equity

Purchase of a Partner’s Interest ADMISSION OF A PARTNER Purchase of a Partner’s Interest To illustrate, assume Partner A and B have capital accounts of $20,000 each. They each agree to sell 25% of their interest to new Partner C in exchange for $13,000 in cash. Assuming that the partnership has $50,000 in cash and $10,000 in liabilities, the effect on the partnership’s accounting equation would be as follows: Where is the $13,000 cash recorded? Remember the cash is received by Partners A and B personally from Partner C so it is recorded on their personal records, not the records of the partnership Notice that only the change in partnership equity is recorded by the partnership Regardless of the amount paid by Partner C, the effect on the partnership would be the same

ADMISSION OF A PARTNER Investment of Assets in a Partnership Liabilities Partners’ Equity + = The admission of a new partner by an investment of assets is a transaction between the new partner and the partnership The partnership receives assets from the new partner in exchange for an interest in the partnership As a result, both the net assets and total partners’ equity will increase for the partnership The only accounting complication occurs when the new partner’s investment differs from the capital equity acquired When those amounts are not the same, the difference is considered a bonus either to the existing (old) partners or to the new partner

ADMISSION OF A PARTNER Investment of Assets in a Partnership Bonus to Existing Partners To illustrate, assume Partner A and B have capital accounts of $20,000 each and split income 50/50. Partner C pays the partnership $15,000 in order to receive a 20% interest in the partnership. The partnership has $50,000 in cash and $10,000 in liabilities before the admission of Partner C. What is the effect on the Partnership’s accounting equation? Assets = Liabilities + Partners’ Equity = + Before admission of new partner $50,000 $10,000 $40,000 Cash increases by $15,000 Partners’ equity increases by $15,000 After admission of new partner = + $65,000 $10,000 $55,000

ADMISSION OF A PARTNER Investment of Assets in a Partnership Bonus to Existing Partners What is Partner C’s portion of the Partner’s Equity? Partner C is to receive a 20% interest in the partnership = 20% x $55,000 total partners’ equity = $11,000 A complexity arises due to Partner C contributing $15,000 cash but only receiving $11,000 in partnership equity What happens with the $4,000 difference between the $15,000 net increase in the total partners’ equity and the $11,000 increase to Partner C’s equity? The $4,000 difference is a bonus to the existing partners which is allocated 50/50 to Partner A and B’s capital accounts in accordance with their income splitting ratio

ADMISSION OF A PARTNER Investment of Assets in a Partnership Bonus to New Partners To illustrate, assume Partner A and B have capital accounts of $20,000 each and split income 50/50. Partner C pays the partnership $15,000 in order to receive a 40% interest in the partnership. The partnership has $50,000 in cash and $10,000 in liabilities before the admission of Partner C. What is the effect on the Partnership’s accounting equation? Assets = Liabilities + Partners’ Equity Before admission of new partner = + $50,000 $10,000 $40,000 Cash increases by $15,000 Partners’ equity increases by $15,000 After admission of new partner + $65,000 = $10,000 $55,000

ADMISSION OF A PARTNER Investment of Assets in a Partnership Bonus to New Partners What is Partner C’s portion of the Partner’s Equity? Partner C is to receive a 40% interest in the partnership = 40% x $55,000 total partners’ equity = $22,000 A complexity arises due to Partner C contributing $15,000 cash but receiving $22,000 in partnership equity What happens with the $7,000 difference between the $15,000 net increase in the total partners’ equity and the $22,000 increase to Partner C’s equity? The existing partners are giving Partner C a bonus of $7,000 from their equity accounts which they split 50/50 in accordance with their income splitting ratio

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

WITHDRAWAL OF A PARTNER Payment from Partners’ Personal Assets The Partnership’s Accounting Equation: Assets Liabilities Partners’ Equity = + Withdrawal by payment from partners’ personal assets is a personal transaction between the partners The amount paid does not affect the partnership’s accounting equation; the cash is paid personally from the remaining partners’ personal assets In the partnership, the only effect is that the withdrawing partner’s capital balance is transferred to the remaining partners Remaining partners’ equity Withdrawing partners’ equity

Payment from Partners’ Personal Assets WITHDRAWAL OF A PARTNER Payment from Partners’ Personal Assets To illustrate, assume Partner A, B, and C have capital accounts of $20,000 each. Partner A and B agree to pay $12,000 each in exchange for one-half of C’s total interest. Assuming that the partnership has $70,000 in cash and $10,000 in liabilities, the effect on the partnership’s accounting equation would be as follows: Where is the $12,000 cash recorded that was paid by Partner A and B? Remember the cash is paid by Partners A and B personally to Partner C so it is recorded on their personal records, not the records of the partnership Notice that only the change in partnership equity is recorded by the partnership Regardless of the amount paid to Partner C, the effect on the partnership would be the same

Payment from Partnership Assets WITHDRAWAL OF A PARTNER Payment from Partnership Assets Assets Liabilities Partners’ Equity = + The withdrawal of a partner by payment of partnership assets is a transaction between the withdrawing partner and the partnership The partnership pays assets in exchange for the withdrawing partner’s interest in the partnership As a result, both the net assets and total partners’ equity will decrease for the partnership The only accounting complication occurs when the amount paid differs from the withdrawing partner’s capital balance When those amounts are not the same, the difference is considered a bonus either to the departing partner or to the remaining partners

WITHDRAWAL OF A PARTNER Payment from Partnership Assets Bonus to Departing Partners To illustrate, assume Partner A, B, and C have capital accounts of $20,000 each and split income 1:1:1. Partner C retires from the firm and receives $24,000 for her partnership interest. Assuming that the partnership has $70,000 in cash and $10,000 in liabilities, the effect on the partnership’s accounting equation would be as follows: Assets = Liabilities + Partners’ Equity + $60,000 Before withdrawal of partner $70,000 = $10,000 Cash decreases by $24,000 Partners’ equity decreases by $24,000 After withdrawal of partner = + $46,000 $10,000 $36,000

WITHDRAWAL OF A PARTNER Payment from Partnership Assets Bonus to Departing Partners Since Partner C received $24,000 for her $20,000 interest in the partnership, the other two partners are giving Partner C a $4,000 bonus Partner A and B allocate the bonus to their capital accounts on the basis of their income splitting ratio of 1:1 The bonus may be paid due to the partnership’s worth exceeding book value or the remaining partners desire to remove Partner C from the partnership

WITHDRAWAL OF A PARTNER Payment from Partnership Assets Bonus to Remaining Partners To illustrate, assume Partner A, B, and C have capital accounts of $20,000 each and split income 1:1:1. Partner C retires from the firm and receives $18,000 for her partnership interest. Assuming that the partnership has $70,000 in cash and $10,000 in liabilities, the effect on the partnership’s accounting equation would be as follows: Assets Partners’ Equity Liabilities + = + Before withdrawal of partner $70,000 = $10,000 $60,000 Cash decreases by $18,000 Partners’ equity decreases by $18,000 After withdrawal of partner = + $52,000 $10,000 $42,000

WITHDRAWAL OF A PARTNER Payment from Partnership Assets Bonus to Remaining Partners Since Partner C received $18,000 for her $20,000 interest in the partnership, she is giving the other partners a $2,000 bonus Partner A and B allocate the bonus to their capital accounts on the basis of their income splitting ratio of 1:1 The bonus may be paid due to the partnership’s recorded assets being overvalued, the partnership has a poor earnings record, or Partner C is anxious to leave the partnership

LIQUIDATION OF A PARTNERSHIP A partnership liquidation terminates the business Liquidation involves: selling the non-cash assets of the firm allocating any gain or loss from the sale to the partners’ capital accounts paying the partnership liabilities, and distributing any remaining cash to the partners, based on their capital balances

LIQUIDATION OF A PARTNERSHIP No Capital Deficiency To illustrate, assume Partner A, B, and C have capital accounts of $10,000 each and split income 3:2:1. The partnership has cash of $5,000, inventory of $40,000, and supplies of $3,000 with liabilities equal to $18,000 Step 1 and 2: Sell the non-cash assets and allocate any gain or loss to the partners’ capital accounts Assuming that the inventory and supplies are sold for $31,000 in total resulting in a $12,000 loss, the effect on the partnership’s accounting equation would be as follows: The loss is allocated to the partners’ capital based on their income ratios: Partner A (3/6 x $12,000) $6,000; Partner B (2/6 x $12,000) $4,000; and Partner C (1/6 x $12,000) $2,000.

LIQUIDATION OF A PARTNERSHIP No Capital Deficiency Step 3: Pay partnership liabilities The $18,000 of accounts payable would be paid before any money is allocated to the partners Step 4: Distribute remaining cash to partners based on their capital balances Once creditors are paid, any remaining cash can be paid to the partners based on the balances of their capital accounts In this example, all partners had credit balances in their capital accounts so they were allocated the amount of cash equal to their balances. This situation is called no capital deficiency.

LIQUIDATION OF A PARTNERSHIP Capital Deficiency A partner’s capital balance may have a debit balance due to recurring net losses, excessive drawings, or losses from the realization during liquidation. A debit balance in the capital account is referred to as a capital deficiency. To illustrate, assume the same example as previous except that the inventory and supplies are sold for $19,000 resulting in a loss of $24,000. Step 1 and 2: Sell the non-cash assets and allocate any gain or loss to the partners’ capital accounts The loss is allocated to the partners’ capital based on their income ratios: Partner A (3/6 x $24,000) $12,000; Partner B (2/6 x $24,000) $8,000; and Partner C (1/6 x $24,000) $4,000 The allocation results in a debit balance for Partner A’s capital of $2,000. The capital deficiency of $2,000 means that Partner A owes $2,000 to the partnership.

LIQUIDATION OF A PARTNERSHIP Capital Deficiency Step 3: Pay partnership liabilities The $18,000 of accounts payable would be paid before any money is allocated to the partners. Step 4: Distribute remaining cash to partners based on their capital balances. Once creditors are paid, any remaining cash can be paid to the partners based on the balances of their capital accounts. In this case, since Partner A has a debit balance, Partner A either needs to pay $2,000 to the partnership or, if Partner A is not able to pay, then the two other partners with credit balances must absorb the loss Assuming Partner A is not able to pay the $2,000, it would be allocated to Partner B and C in accordance with their relative income ratio of 2/3 for Partner B and 1/3 for Partner C (based on the original income ratio of 3:2:1 for the partnership).

LIQUIDATION OF A PARTNERSHIP Capital Deficiency Step 4: Distribute remaining cash to partners based on their capital balances continued Once Partner A’s capital deficiency is absorbed by the other partners’ capital accounts, the partnership can then pay the $6,000 cash to Partner B and C based on their capital balances

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