Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw- Hill/Irwin Chapter 10 Partnerships: Formation, Operation, and Changes in Membership

10-2 Understand and explain the nature and regulation of partnerships. Learning Objective 1

10-3 What is a Partnership? An association of two or more persons who ■ are co-owners of a business, and ■ share profits and losses in an agreed-upon manner. ABC Company AB

10-4 What is a “Person”? An individual A corporation Another partnership Z Corp T&D Partnership

10-5 Partnerships: Pros & Cons Advantages ■ Ease of formation ■ Lack of formality ■ Single taxation (see following slide) Disadvantages ■ Unlimited liability (for general partnerships) ■ Difficulty in disposing of partnership interests ■ Mutual agency

10-6 Partnership Form of Organization: Income Tax Reporting Single Taxation of Partnership Earnings ■ Partnerships only report their earnings—they are not taxed at the business entity level (as are corporations). ■ Partnerships file IRS Form 1065, which shows the allocation of profits among partners. ■ Partners report their share of profits on their individual IRS Form 1040 return. AB Partnershi p AB Uncle Sam

10-7 Regulation Each state regulates the partnerships that are formed in it. Most states begin with a model act and then modifies it to fit that state’s business culture and history. Most have now adopted the Uniform Partnership Act of 1997 (UPA 1997) as their model act.

10-8 Regulation: The Uniform Partnership Act (UPA) The UPA 1997 covers: ■ Relations of partners to one another. ■ Relations of partners to persons dealing with the partnership. ■ Dissolution and winding up of the partnership.

10-9 The Partnership Agreement What is a partnership agreement? A written expression of what the partners have agreed to. Examples of areas addressed: ■ Manner of sharing profits. ■ Limitations on withdrawals. ■ Rights of partners. ■ Settling with withdrawing partners. ■ Expulsion of partners. ■ Conflicts of interest.

10-10 Practice Quiz Question #1 Which of the following is not one of the advantages of general partnerships? a. Ease of formation b. Unlimited liability c. Lack of formality d. Single taxation

10-11 Practice Quiz Question #1 Solution Which of the following is not one of the advantages of general partnerships? a. Ease of formation b. Unlimited liability c. Lack of formality d. Single taxation

10-12 Learning Objective 2 Understand and explain the differences among different types of partnerships.

10-13 Types of Partnerships General Partnerships ■ All partners have unlimited liability. ■ Creditors can go after the personal assets of any or all of the partners.

10-14 Types of Partnerships Limited Partnerships ■ Limited partners have limited liability to partnership creditors if the partnership is unable to pay its debts. ● Limited partners’ risk is limited to their invested capital. ● Thus, personal assets are not at risk. ■ At least one of the partners must be a general partner.

10-15 Types of Partnerships Limited Liability Partnerships (LLPs) ■ A partner’s personal assets are at risk only for ● his or her own negligence and wrongdoing, ● the negligence and wrongdoing of those under his or her control, but ● not debts. ■ Since 1993, many accounting firms have changed from general partnerships to LLPs.

10-16 Types of Partnerships Limited Liability Limited Partnerships (LLLPs) ■ Like a limited partnership, must have at least one general partner. ■ General partners manage the partnership. ■ Big difference relates to the liability of general partners: ● No personal liability for partnership obligations (like a limited partner) ● Not liable for wrongdoing of other partners—just personal decisions and decisions of those supervised

10-17 Practice Quiz Question #2 Which of the following statements is true? a.The partners in a general partnership have limited liability. b.At least two of the partners in a limited partnership must be general partners. c.Partners in an LLP are not responsible for their own actions. d.Limited liability limited partnerships must have at least one general partner.

10-18 Practice Quiz Question #2 Solution Which of the following statements is true? a.The partners in a general partnership have limited liability. b.At least two of the partners in a limited partnership must be general partners. c.Partners in an LLP are not responsible for their own actions. d.Limited liability limited partnerships must have at least one general partner.

10-19 Learning Objective 3 Make calculations and journal entries for the formation of partnerships.

10-20 Partners’ Accounts Each partner can have ■ a capital account. ■ a drawing account (a contra capital account—closed out at year-end). ■ a loan account (loans usually earn interest—a partnership expense). Partnerships do NOT use a retained earnings account. DR CR

10-21 Recording Capital Contributions Keep it FAIR! ■ Current Fair Market Values should be used to record ● noncash assets contributed to a partnership. ● liabilities assumed by a partnership. ABC Partnership

10-22 $150,000 + $175,000 = $325,000 Partnership Formation Example Brian and Spencer wish to form the B&S partnership. Brian contributes land with a book value of $65,000 and a current value of $150,000 and a building with a book value of $142,000 and a current value of $175,000. Spencer will contribute cash. If the partners plan to share profits and losses equally after the formation of the partnership and assuming they have agreed to equal capital contributions, how much cash will Spencer have to contribute to form the partnership?

10-23 Comprehensive Partnership Creation Problem The partnerships of Brad & Mike (B&M) and Austin and Justin (A&J) began business on 1/1/X1; each partnership owns one retail appliance store. The two partnerships agree to combine as of 7/1/X8 to form a new partnership, BAM-J Discount Stores. REQUIRED Given the information on the next two slides, 1.Prepare the journal entries to record the initial capital contribution after considering the effect of this information. Use separate entries for each of the combining partnerships. 2.Prepare a schedule computing the cash contributed or withdrawn by each partner to bring the initial capital balances into the profit and loss sharing ratio.

10-24 Comprehensive Partnership Creation Problem 1.Profit and loss ratios. The profit and loss sharing ratios for the former partnerships were 40% to Brad and 60% to Mike, and 30% to Austin and 70% to Justin. The profit and loss sharing ratio for the new partnership is Brad, 20%; Mike, 30%; Austin, 15%; and Justin, 35%. 2.Capital investments. The opening capital investments for the new partnership are to be in the same ratio as the profit and loss sharing ratios for the new partnership. If necessary, certain partners may have to contribute additional cash, and others may have to withdraw cash to bring the capital investments into the proper ratio. 3.Accounts receivable. The partners agreed to set the new partnership’s allowance for bad debts at 3% of the accounts receivable contributed by B&M and 12% of the accounts receivable contributed by A&J. 4.Inventory. The new partnership’s opening inventory is to be valued by the FIFO method. B&M used the FIFO method to value inventory (which approximates its current value), and A&J used the LIFO method. The LIFO inventory represents 85% of its FIFO value. 5.Property and equipment. The partners agree that the building’s current value is approximately 70% of the building’s historical cost, as recorded on each partnership’s books. 6.Unpaid liability. After each partnership’s books were closed on 6/30/X8, an unrecorded merchandise purchase of $1,500 by A&J was discovered. The merchandise had been sold by 6/30/X8. 7.The 6/30/X8 postclosing trial balances of the partnerships follow

10-25 Comprehensive Partnership Creation Problem Account Brad & Mike Trial Balance – June 30, 20X8 Austin & Justin Trial Balance – June 30, 20X8 Cash 25,000 22,000 Accounts Receivable 100, ,000 Allowance for doubtful accounts 2,000 6,000 Inventory 175, ,000 Building & Equipment 105, ,000 Accumulated Depreciation 24,000 61,000 Accounts Payable 40,000 60,000 Notes Payable 100, ,000 Brad, Capital 95,000 Mike, Capital 144,000 Austin, Capital 65,000 Justin, Capital 139,000 Totals 405, ,000 1.Prepare the journal entries to record the initial capital contribution after considering the effect of this information. Use separate entries for each of the combining partnerships. 2.Prepare a schedule computing the cash contributed or withdrawn by each partner to bring the initial capital balances into the profit and los sharing ratio.

10-26 Comprehensive Problem Solution PART 1 Summary of changes to carrying values: Brad & MikeAustin & Justin Increase allowance for bad debt$(1,000)$(12,000) Increase inventory) 21,000 Increase buildings and equipment(7,500)13,000) Increase accounts payable(1,500) Net increase$(8,500)$20,500) Brad (40%)$(3,400)Austin (30%)$6,150 Mike (60%)(5,100)Justin (70%)14,350 $(8,500)$20,500 Allocate to:

10-27 Comprehensive Problem Solution PART 1: Summary of changes to carrying values:

10-28 Comprehensive Problem Solution Brad & Mike Journal Entry:

10-29 Comprehensive Problem Solution Austin & Justin Journal Entry:

10-30 Comprehensive Problem Solution PART 2 BradMikeAustinJustinTotal Profit sharing percentage20%30%15%35% Capital balances91,600138,90071,150153,350455,000 Capital balances required using profit and loss sharing percentages 91,000136,50068,250159,250 Capital contribution or (withdrawal) (600)(2,400)(2,900)5,900