College Accounting, by Heintz and Parry Chapter 20: Accounting for Partnerships

Nick looked nervous when Eddie walked in that Monday. “Eddie, come talk to me in the back office.” Eddie heard the urgency in his voice and followed him quickly. “Eddie, I talked over the weekend to Rick Stagger, the singer in Forever Run, and he wants to invest in the business so we can open new stores near the other two area colleges.” “You know Rick Stagger? Could you get him to listen to a tape of Eddie and the Losers?” “Maybe someday, but this isn’t about you right now, kid. I worked with some of Rick’s garage bands before he ever formed Forever Run. He knows that rock stardom isn’t forever, and he wants to invest some of his money into something fun and profitable. I’d love to have more stores, but it’s a big decision. What do you see as the pros and cons of taking on a partner? Question: What are some pros and cons of taking on a partner?

Answer: Many of the pros and cons depend on the individual circumstances. In general, some of the pros and cons of taking on a partner are: PROS: 1) partners can bring in new abilities or experience (not really true in this case) 2) partners can bring in more capital 3) partners can improve the ability of the business to borrow money CONS: 1) any partner can enter into contracts that are binding for the partnership, just one example of the loss of control over the business that accompanies the entry of a partner 2) a partner can’t sell his part of a business without consent from the other partner(s) 3) any exit of a partner ends the partnership and creates the need for a new partnership agreement (or a new start as a sole proprietorship)

After Nick and Eddie discussed the pros and cons, Nick wanted to know how the accounting might be different. “For example, Rick wants to invest $150,000. What would the entry for that be?” “That one is simple. It’s the same entry we make when you invest money, except that Rick would have his own capital account.” Date Description P. R. Debit Credit 2000 July 10 Cash 150, Rick Swagger, Capital 150,000.00

“However, you will probably want to make an entry to put your assets onto the books, because this is a whole new business. Besides, if some of your assets are currently worth more or less than their book value, it would only be fair to all of the partners to use current market value to measure the capital each partner contributes to the partnership. Therefore, one of the first two entries ever made by the partnership would look something like this.” Date Description P. R. Debit Credit 2001 July 10 Cash 7, Accounts Receivable 2, Merchandise Inventory 13, Supplies Prepaid Insurance Land 25, Building 110, Accounts Payable 4, Mortgage Payable 33, Nick Flannery, Capital 120,000.00

Eddie wasn’t sure if Nick had his eyes wide open about all of this. “Did you two discuss how you would divide up the net income of the business?” “No, I hadn’t really thought about that part yet.” “Well, you’d better think about it. Did you know that partners who don’t have a written agreement are legally obligated to split the money evenly?” “Okay, so we need to get something in writing, and quickly! What are some typical methods to split the money?” “Most partnerships use some combination of the following: 1) a salary allowance to the partners based on their experience, expertise, and/or hours devoted to the business, 2) an interest allowance to compensate each partner for the money that he or she has invested, and 3) a ratio or percentage for dividing any excess or deficit that remains.

Nick’s head was spinning. “None of that is going to make sense to me until you provide an example with numbers on paper.” “Fair enough. Let’s say you agree to the following: 1) salaries of $45,000 for you, and $10,000 to Rick for signing autographs at the grand openings and again at Christmas, 2) 10% interest on your beginning capital (10% X $150,000 = $15,000 for Rick, 10% X $120,000 = $12,000 for you), and 3) the rest is split 60/40, with you getting the 60%. If the business has net income of $92,000, the division of net income would look like this.” Allocation of net income: Flannery Swagger Total Salary allowances 45, , , Interest allowance 12, , , Remaining income (split 60/40) [92,000-(55,000+27,000)]=10,000 6, , , Allocation of net income 63, , , Question: How would this calculation change if net income were only $77,000?

Answer: The salary and interest allowances would be unchanged. However, at that point, the allocations would exceed the net income, so the excess would be split 60/40 as a deduction from the net income allocated. The calculation looks like this: Allocation of net income: Flannery Swagger Total Salary allowances 45, , , Interest allowance 12, , , Excess of allowances over income [77,000-(55,000+27,000)]=(5,000) (3,000.00) (2,000.00) (5,000.00) Allocation of net income 54, , ,000.00

Nick was pleased by this discussion. “Yeah, I’m sure Rick and I can work out something fair. In fact, if we have another good year, he said that he could probably convince the other guys in the band to invest. Can we take on another partner or three in a year?” “Yes and no. It creates a new partnership, but it can be accomplished by an entry to the old books. This frequently happens when the new partner contributes only money. It could be as simple as the entry we said we suggested to put Rick into the business (debit cash and credit capital). Sometimes, however, the new partner pays money to the old partners for part of their existing interest in the business. Let’s say Billy ‘Bones’ Jones paid you $50,000 for 1/3 of your capital and Rick $62,500 for 1/3 of his capital. Don’t forget that your capital is $120,000 and Rick’s is $150,000.” Question: What would be the entry for adding Billy “Bones” Jones a partner?

Answer: The entry is shown below. Notice that the entry has nothing to do with the cash paid (that’s between Billy and the individual partners). If 1/3 of the someone’s ownership is purchased, 1/3 of the capital balance is the amount used for the transaction. Date Description P. R. Debit Credit 2001 July 30 Rick Swagger, Capital (1/3 X 150,000) 50, Nick Flannery, Capital (1/3 X 120,000) 40, Billy Jones, Capital 90, If a partner retires or withdraws, there is similar freedom for the withdrawing partner to get more or less than their capital balance (if all partners agree). For example, if Billy decided he needed to get his money back out a month later (due to a financial emergency), he might be willing to accept only 90% of his capital balance, or $81,000. Question: What would be the debits and credits (and for what amounts) if Billy took $81,000 cash and withdrew from the partnership?

Answer: The entry is shown below. The $9,000 difference is split between Nick and Rick in proportion to their share of the sum of their two capital accounts (Rick’s $100,000 + Nick’s $80,000 = $180,000). The calculation of the split is: Rick gets $9,000 X 100,000/180,000 = $5,000 Nick gets $9,000 X 80,000/180,000 = $4,000 Date Description P. R. Debit Credit 2001 Aug. 30 Billy Jones, Capital 90, Cash 81, Rick Swagger, Capital 5, Nick Flannery, Capital 4, Of course, a partner could receive assets worth more than his capital balance. Question: What would be the debits and credits (and for what amounts) if Billy took $108,000 cash and withdrew from the partnership?

Answer: The entry is shown below. The $18,000 difference is taken from Nick and Rick’s capital in proportion to their share of the sum of their two capital accounts. The calculation of the split this time is: Rick loses $18,000 X 100,000/180,000 = $10,000 Nick gets $18,000 X 80,000/180,000 = $8,000 Date Description P. R. Debit Credit 2001 Aug. 30 Billy Jones, Capital 90, Rick Swagger, Capital 10, Nick Flannery, Capital 8, Cash 108, ”Okay,” Nick concluded, ”my last question about partnerships is: what would happen if Rick and I decided to go out of business someday. How would we decide who gets how much money and other assets?”

Eddie had recently studied liquidations at school, so he was ready to provide an example on paper. “Let’s imagine your balances two years down the road. Step one is to sell your non-cash assets. Let’s say you get $20,000 more than book value.” Cash Other Assets Liabilities Nick F., Cap. Rick S., Cap. Balances 18, ,000 40, , ,000 Asset Sale +342, , ,000 +8,000 Balances 360, , , ,000 “The gain on sale would be split in proportion to the agreement for dividing income and losses. Assuming that salaries and interest are up-to-date, this means a 60/40 split. $20,000 X 60% = 12,000 for you and the remaining $8,000 for Rick.” Question: What would be the debits and credits (and for what amounts) when this transaction is journalized?

Answer: There would be two entries made, one to record the sale at a gain and one to distribute the gain to the partners. These are the entries: Date Description P. R. Debit Credit 2003 July 10 Cash 342, Other Assets 322, Gain on Sale of Assets 20, Gain on Sale of Assets 20, Nick Flannery, Capital 12, Rick Swagger, Capital 8,000.00

Eddie continued his explanation of how to account for the liquidation of a partnership. “Step two is to pay your liabilities. This would normally be at book value.” Cash Other Assets Liabilities Nick F., Cap. Rick S., Cap. Balances 18, ,000 40, , ,000 Asset Sale +342, , ,000 +8,000 Balances 360, , , ,000 Liab. Paid - 40, ,000 Balances 320, , ,000 Question: What would be the debits and credits (and for what amounts) when this transaction is journalized?

Answer: This entry is simple, like any payment of liabilities: Date Description P. R. Debit Credit 2003 July 10 Liabilities 40, Cash 40,000.00

“The third and last step is to pay the remaining cash to the partners.” Cash Other Assets Liabilities Nick F., Cap. Rick S., Cap. Balances 18, ,000 40, , ,000 Asset Sale +342, , ,000 +8,000 Balances 360, , , ,000 Liab. Paid -40, ,000 Balances 320, , ,000 Distribution -320, , ,000 Balances Question: What would be the debits and credits (and for what amounts) when this transaction is journalized?

Answer: This entry closes all remaining accounts of the business: Date Description P. R. Debit Credit 2003 July 10 Nick Flannery, Capital 152, Rick Swagger, Capital 168, Cash 320,000.00

Nick was satisfied with the information he received. “I’ll want to talk to a lawyer, of course, but I think I’m going through with the deal. I feel like a partnership reduces my risk, and the multiple locations should both reduce the volatility of our returns and give us some economies of scale.” “You’ve been reading your investing book again, haven’t you, Nick? The whole thing is exciting, and I hope it works out for us. I can still use the word ‘us,’ can’t I?” “Of course, Eddie. In fact, I think this will create chances for you to learn and grow. I may consult our CPA more, but you’re still my ace in-house accountant.”