Accounting for Partnerships Chapter 12

Definition of a Partnership defined in legal terms as two or more people combining resources to make a profit.  A partnership also requires a commitment not only to the business, but to each other and to the good of all. All businesses have a responsibility to treat employees and customers with respect, fairness and dignity.

Definition of a Partnership Partnerships, have the added dimension of many owners; each with the authority to make decisions that can have positive or negative effects on the business. 

Types of Partnerships General Limited Limited Liability

General Partnership owners share the management of a business, and each partner would be personally liable for all debts and obligations incurred. This means that each partner is responsible for, and must assume the consequences of, the actions of the other partner(s).

Terms of the Partnership In order to establish the terms of the partnership and to protect yourself in the event of a disagreement or dissolution of a partnership, a partnership agreement should be drawn up.

Profit Sharing You would share in the profits according to the terms of the partnership agreement. If there is no agreement or it is not covered, all profits and losses would be divided equally among all partners.

Advantages of Partnership Ease of formation Low start-up costs Additional sources of investment capital Possible tax advantages Limited regulation Broader management base

Disadvantages of Partnership Unlimited liability Divided authority Difficulty in raising additional capital Hard to find suitable partners Possible development of conflict between partners Partners can legally bind each other without prior approval Lack of continuity No name protection

Resources Canada Business is a government information service for businesses and start-up entrepreneurs in Canada. United States Small Business Administration Question 1: You and your best friend have decided to start up a catering company using a partnership ownership model. List five things you would want in the partnership agreement and why. Question 2: From the list of advantages and disadvantages, pick the two from each list you think are the most important and explain why.

Limited and General Partnerships Most partnerships formed are general partnerships. The advantages and disadvantages outlined in the previous activity apply to all partnerships. The one exception is the issue of unlimited liability. One way around this disadvantage is to form a limited partnership.

What is a Limited Partnership? involves limited partners who combine only capital. They are not as involved in managing the business and cannot be liable for more than the amount of capital they have contributed. This is known as limited liability. also involves general partners, who are more involved in management. General partners are fully liable for the debts and obligations of the business, but may be entitled to a greater share of the profits.

Limited Liability Partnerships Established to protect innocent partners from malpractice or negligence claims resulting from the acts of another partner Usually found with lawyers and accounts Identified by “L.L.P” Remaining partners are not personally liable for the actions of the negligent partner, however they are personally liable for the other partnership debts

Dividing Net Income or Net Loss One advantage in forming a partnership is that all partners share the risk in forming the business. That means that, if there is a loss, it is shared among all partners. Of course, if there is a net income, it is also shared. The partnership agreement should outline the manner in which the income or loss is divided among the partners. This is known as the income ratio. If there is no partnership agreement, or it is not covered in the partnership agreement, then all profits or losses are shared equally.

External Resources-More Reading Partnerships: To be or not to be: http://www.smallbusinessbc.ca/post/partnerships-be-or-not-be Sole Proprietorship or Partnership http://sbinfocanada.about.com/cs/startup/a/formsbusiness.htm Corporation, Partnership or Sole Proprietorship http://www.canadabusiness.ca/eng/page/2853/

Formation of a Partnership When two or more people come together to form a partnership, they will bring their skills and talents to the venture. They may also bring assets and liabilities from an existing business or from personal areas. Any asset brought into the partnership must be recorded at fair market value. This value must be agreed upon by all partners. Let's look at an example:

Establishing a Partnership Assume that Jenny Adams and Kendall Harris agree to start a partnership. Adams brings $2500 cash and an automobile from her existing business, that cost $24 000 and has $6000 in accumulated depreciation. Harris brings in $10, 000 and no other assets. The partners agree that the fair market value of the automobile is $16 000. The entry to record the formation of the partnership would be:

Journalize May 1 Cash 2500 Automobile 16000 J Adams Capital 18 500 To record investment of Adams. May 1   Cash 10 000 K. Harris, Capital  10 000  To record investment Harris.

Dividing Net Income or Net Loss There are many ways of allocating income or losses. Some of the more common income ratios are: a certain percentage for each partner (e.g. four partners earning 25% each) an amount based on a fraction (e.g. three partners earning 1/3 each) an amount based on a proportion (e.g. three partners with a break down of income based on a 4:3:2 ratio) an amount based on the balance in the partner's capital accounts a fixed salary plus an allocation from the list above interest on the capital balance plus an allocation from the list above

Dividing Net Income or Net Loss The entry to record the distribution of net income or loss to partners is not much different than that of a sole proprietorship. The temporary accounts are closed to the Income Summary account and the net income is divided up from there. Look at an Example:

Dividing Net Income or Net Loss Assume the partnership of Adams, Harris and Downs divides income on an equal basis. The revenue for the year was $175 000 and the expenses were $100 000. The first two (simplified) closing entries would be: Dec. 31 Revenues $175 000   Income Summary $175 000  To close temporary accounts with a credit balance         Dec 31 Income Summary 100 000   Expenses  100 000  To close temporary accounts with a debit balance

Dividing Net Income or Net Loss The balance in the Income Summary account, after these transactions have been posted, would be $75 000. This, as we know, represents the net income that must be divided between the three partners. The partners divide all profits equally, so the formula to determine how much will be allocated to each partner will be: $75 000 X 1/3 = $25 000

Dividing Net Income or Net Loss The entry to allocate the amount of net income to each partner's capital account would be: May 1 Income Summary $75 000   J. Adams, Capital   $25 000   K. Harris, Capital   25 000   T. Downs, Capital  25 000  To allocate the net income to the partners

Dividing on a Fractional Basis Two partners agree to a 3:2 ratio this means that 3/5 or 60% is allocated to the first partner and the second partner has an allocation of 2/5 or 40% Why is 5 the divisor??? 3:2 add the two numbers together = 5 If the ratio was 3:4 what would the allocation be?

Your turn: Assume that Jenny Adams and Kendall Harris have a partnership of 2:3 for income/loss allocation. Jenny has a capital balance of $60 000 and Harris has a capital balance of $80 000. Their partnership agreement states that they are to be given a salary of $7 000 each, an interest allowance of 5% on their capital balance. The business earned $24000 during the past year.

Answer

Journalize Income Summary 24000 J. Adams, Capital 11200 K. Harris, Capital 12800 To allocate the net income to the partners

What happens if the company does not earn enough net income to cover the salaries or the interest allowances? The salaries and allowances must be allocated, but then the capital accounts must then be decreased by the amount of the shortage, using the income ratio. Let's look at a similar example to the one above, but with a lower net income:

Assume that Jenny Adams and Kendall Harris have a partnership Assume that Jenny Adams and Kendall Harris have a partnership. Jenny has a capital balance of $60 000 and Harris has a capital balance of $80 000. Their partnership agreement states that they are to be given a salary of $10 000 each, an interest allowance of 5% on their capital balance and the remainder to be allocated at 40% for Adams and 60% for Harris. The business earned $17 000 during the past year.

Journalize The entry to allocate the net income in this example would be: May 1Income Summary $17 000   J. Adams, Capital  $9000   K. Harris, Capital  8000  To allocate the net income to the partners

Admission of a New Partner From a legal standpoint, if an existing partnership decides to admit a new partner, the existing partnership is dissolved and a new business begins. While this sounds like a big accounting event, what usually happens is that the new partner's Capital account is added to the books of the current business, and everything else continues as usual. There are two ways for a new partner to be admitted into the business. The partner can buy part of the existing share of one or more partner, or they can "buy their way in" by investing in the business.

Buying Existing Partners' Share When an existing partner decides to sell part of his or her share to someone else, that transaction is a personal one between two people. If the new partner offers to pay more than the current value to be admitted to the partnership, then the extra money is kept by the existing partner. There is no change to the total assets, liabilities or capital. The only change is to the breakdown of the partner's capital.

Example Assume that Jenny Adams and Kendall Harris have a partnership, and each have $60 000 in their capital account. Ted Downs offers them $44 000 ($22 000 each) for a one third interest. Ted is offering more than the $20 000 it would normally cost, because Jenny and Kendall have built such a strong business, Ted feels it is worth an extra $2000 each. The entry would be:

Journalize General Journal J. Adams, Capital $20 000 K. Harris, Capital  20 000  T. Downs, Capital  $40 000 To record the admission of Ted Downs as a partner  Why did Jenny and Kendall's capital only go up $20 000 when Ted paid them $22 000 each? The purchase is a personal transaction. The $2000 extra goes directly to Jenny and Kendall. Ted paid the extra amount because he thinks that the business will do well.

Investment of Assets by a New Partner The second way a new partner can be admitted into an existing partnership is by investing cash or other assets in the business. This type of transaction has no effect on the other partner's capital.

Example: Assume that Jenny Adams and Kendall Harris have a partnership and each have $60 000 in their capital account. Ted Downs wants to be part of the business and brings $14 000 and a car with a fair market value of $18 000. The entry would be:

Journalize May 1 Cash $14 000 Automobile 18 000 T. Downs, Capital  $32 000  To record the admission of Ted Downs as a partner 

Bonuses In Partnerships There are many reasons why partners join or withdraw from partnerships. Assume that Ted Downs wanted to join this partnership because Jenny and Kendall have worked hard growing the business over five years. Jenny and Kendall would welcome Ted into the partnership, but they may want Ted to pay a little extra (a bonus) to the existing partners. A bonus to the existing partners means that the new partner pays more than the amount the capital is credited. The extra amount gets credited to the existing partners' capital accounts. This extra capital is allocated based on the income ratios outlined in the partnership agreement.

Bonuses In Partnerships There could also be a situation where the existing partners would be willing to give up some of their capital to bring a partner in whose special talents or name recognition would help the business. If your partnership decides to expand to Quebec, you may be willing to give up some of your capital to bring in a local, French speaking partner, who knows the area and the potential customers. A bonus to the new partner means that the new partner pays less than the amount that the capital is increased. The extra comes from the existing partner's capital accounts (they are debited). The decrease in the capital is allocated based on the income ratios.

Withdrawal of a Partner Like the admission of a new partner, when an existing partner leaves, the partnership is dissolved. Usually, however, this type of situation is covered in the partnership agreement, and what happens is that the partner's Capital account is deleted from the books of the business, and everything else continues as usual. There are two ways for a partner to be deleted from the business. The existing partners can buy the partner's share with personal funds, or they can "buy out" the partner using business assets.

Existing Partners Using Personal Funds to Buy Out Partner If a partner is leaving, the remaining partners may choose to buy him/her out with their personal money. As is the case when a new partner buys an existing partner's ownership share, this is a personal transaction between the partners, and the only change on the books of the business will be a change in the capital accounts.

Example: Assume that Jenny Adams, Kendall Harris and Ted Downs have a partnership with $80 000, $110 000, and $ 55 000 in their capital accounts, respectively. Jenny has worked hard over the years and wants to retire. Kendall and Ted offer Jenny $44 000 each ($88 000 total) for a 50% share of her capital. Jenny accepts and starts looking for some lakefront property to retire to. The entry would be:

Journalize May 1 J. Adams, Capital 80 000 K. Harris 40 000 T. Downs, Capital  40 000  To record the withdrawal of partner J. Adams  Why did Jenny' s capital only go down $80 000 when Ted and Kendall paid her $88 000 total? The purchase is a personal transaction. The $8000 extra goes directly to Jenny. Ted and Kendall paid the extra amount because they realize that Jenny has worked hard to build a successful business, and it is worth the extra money paid.

Using Partnership Funds to Pay Withdrawing Partner Using the assets of a business to pay a departing partner is a little trickier. If everything was normal, the business would simply pay the departing partner the amount in his/her capital account. There are, however, many issues involved, as both the departing owner's capital and the assets of the business are decreasing. Some issues that must be taken into account are:

Are the assets of the business recorded at fair market value? recording depreciation is an estimate of the decline in value of fixed assets. The depreciation expense causes net income to go down and thus decreases all partners' capital. The departing partner may claim that the assets have been depreciated too much, resulting in his/her current capital balance being too low. On the other side, the remaining partners may claim that the fixed assets have not been depreciated enough, resulting in the departing partner's capital account being too high. Most partnership agreements allow for assets to be valued at fair market value if a partner is leaving. The value of the assets on the books cannot change, however, as this would violate the Cost Principle.

How successful is the business? As you learned earlier, Goodwill is taken into account when a business is sold. If the departing partner has helped build a solid business with the potential for increased further earnings, it could be agreed that he/she receives more than the Capital balance. If the business is doing poorly because of the departing partner, then it could be agreed that he/she receives less than the Capital balance.

Why is the partner leaving? Do the current partners want the partner out? Is the departing partner in a hurry to leave? These factors have an impact on the amount the departing partner will receive.

The result of all of this is that there is often a bonus involved (either to the outgoing partner or the existing partners) when a partner leaves the business. Let's look at two examples: