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Accounting for Partnerships Lamar Van Dusen

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Accounting for Partnerships Section 1: Forming a Partnership Section Objectives 1. Explain the major advantages and disadvantages of a partnership. 2. State the important provisions that should be included in every partnership agreement. 3. Account for the formation of a partnership.

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Advantages of a Partnership Each partner is taxed individually on his or her share of the partnership’s income.  It pools the skills abilities and financial resources of two or more individuals.  It is easy and inexpensive to form.  A partnership does not pay income tax. Explain the major advantages and disadvantages of a partnership Objective 1

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Disadvantages of a Partnership  Each partner has unlimited liability.  The partnership is a mutual agency.  The business lacks continuity. It has a limited life.  Ownership rights are not freely transferable.

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A partnership agreement is a legal contract forming a partnership and specifying certain details of the operation. ANSWER: QUESTION: What is a partnership agreement Explain the important provisions which should be included in a partnership agreement Objective 2

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 Names of the partners.  Name location and nature of the business.  Starting date of the agreement.  Life of the partnership.  Rights and duties of each partner. Every partnership agreement should contain:

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 Amount of capital to be contributed by each partner Every partnership agreement should contain:  Drawings withdrawals by the partners.  Fiscal year and accounting method.  Method of allocating income or loss to the partners.  Procedures to be followed if the partnership is dissolved or the business is liquidated.

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 Memorandum entry to record formation of partnership.  Investment of assets and liabilities by partners.  Setting up partners’ capital accounts.  Setting up partners’ drawing accounts.  Subsequent investments and permanent withdrawals. Account for the formation of a partnership. Objective 3

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Memorandum Entry to Record Formation of Partnership 20-- Jan. 1 On this date a partnership was formed between Ellen Barret and Jerry Reed to carry on a retail clothing business under the name of Old Army according to the terms of the partnership agreement effective this date.

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20-- Jan. 1 Accounts Receivable 20500.00 Merchandise Inventory 105200.00 Store Equipment 3000.00 Allow. for Doubtful Accts. 1200.00 Notes Payable—Bank 39100.00 Accounts Payable 34700.00 Interest Payable 500.00 Ellen Barret Capital 53200.00 Investment of Ellen Barret Assets that are transferred to a partnership should be appraised and recorded at the agreed-upon fair market value at the time of transfer. Investments of Assets and Liabilities by a Sole Proprietor

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Investment of Cash by Partner New Partner Given Credit for Amount Invested Jan. 1 Cash 28000.00 Jerry Reed Capital 28000.00 Investment of cash by Reed

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Drawing Accounts  Any withdrawal by a partner whether it is cash or some other asset is a return of equity to that partner.  The partner’s drawing account balance reduces that partner’s equity.

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Accounting for Partnerships Section 2: Allocating Income or Loss Section Objectives 4. Compute and record the division of net income or net loss between partners in accordance with the partnership agreement. 5. Prepare a statement of partners’ equities. McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies Inc. All rights reserved.

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Allocating Partnership Income or Loss In step 3 the business determines the distributive share for each partner. Step 1. Close revenue to Income Summary. Step 2. Close expenses to Income Summary. Step 3. Close Income Summary to the partners’ capital accounts. Step 4. Close each partner’s drawing account to the partner’s capital account. Compute and record the division of net income or net loss between partners in accordance with the partnership agreement Objective 4

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Allocation of Partnership Income or Loss  Based on the partnership agreement.  Allocated equally to each partner if the partnership agreement is “silent.”  Income distribution does not mean cash distribution.

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Agreed Upon Ratio  Step 1: Add the figures given in the ratio. Barret 3 + Reed 2 Example: Barret and Reed agreed that net income should be split in a 3:2 ratio to Barret and Reed respectively.  Step 2: Express each figure as a fraction of the total. Barret’s share 3/5 Reed’s share 2/5  Step 3: Convert each fraction into a percentage. Barret’s share 3/5 60 Reed’s share 2/5 40 Total 5

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Net Income X partner’s share percentage: Agreed Upon Ratio 20-- Dec. 31 Income Summary 100000.00 Ellen Barret Capital 60000.00 Jerry Reed Capital 40000.00 Net Income 100000 Barret’s share 100000 x 60 60000 Reed’s share 100000 x 40 40000

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Capital Account Balances  Step 1: Add the capital account balances. Barret 53200 Reed + 28000 Total 81200  Step 2: Express each balance as a fraction and convert it to a percentage. Barret 53200/81200 65.517 Reed 28000/81200 34.483

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Capital Account Balances Net Income X partner’s share percentage: Net Income 100000 Barret 100000 x 65.517 65517 Reed 100000 x 34.483 34483

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Salary and Interest Allowances  Allowances for partners’ salaries and interest on their investments can be included in the allocation of net income or loss.  Allowances are debited to the Income Summary account and credited to the partners’ capital accounts.  The remaining net income or loss is then allocated in the proper ratio.

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Salary allowances are intended to reward the partners for the time they spend in the business and for the expertise and talents they bring to it. Salary Allowances Salary allowances are withdrawals. Salary allowances do not represent salary expense.

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20-- Dec. 31 Income Summary 52800.00 Ellen Barret Capital 30000.00 Jerry Reed Capital 22800.00  Net Income is 112800. Salary Allowances  Salary allowances for Barret 30000 and Reed is 22800.

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20-- Dec. 31 Income Summary 60000.00 Ellen Barret Capital 36000.00 Jerry Reed Capital 24000.00 Salary Allowances Net Income 112800 Less: Salary Allowances – 52800 Using the agreed upon ratio the amount of net income after salary allowances is allocated 60 to Barret and 40 to Reed. Balance in Income Summary 60000

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Net Loss Net Loss 30000 Their capital accounts are debited decreased. Income Summary Distributed between Ross and Wright. Dec. 31 Sal. All. 52800 Dec. 31 Int. All. 6496 Bal. 89296  Assume net loss 30000  Record the salary allowances of 30000 for Barret and 22800 for Reed.  Record the interest allowances of 4256 to Barret and 2240 to Reed.

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Partnership Financial Statements Income Statement  Same as that for a sole proprietorship.  One exception—on the bottom of the statement the division of net income is shown between the partners. Balance Sheet  Same as that for a sole proprietorship.  One exception—there exists a separate capital account for each of the partners in Partner’s Equity section. Prepare a statement of partners’ equities Objective 5

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OLD ARMY Statement of Partners’ Equities Year Ended December 31 2010 Barret Reed Total Capital Capital Capital Capital Balances Jan. 1 2010 0.00 0.00 0.00 Investment During Year 53200.00 28000.00 81200.00 Net Income Loss for Year 6308.00 2908.00 3400.00 Totals 59508.00 25092.00 84600.00 Less Withdrawals During Year 30000.00 22800.00 52800.00 Capital Balances Dec. 31 2010 29508.00 2292.00 31800.00 Statement of Partners’ Equities Each partner’s salary is treated as a withdrawal on the statement.

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Accounting for Partnerships Partnership Changes Section Objectives 6. Account for the revaluation of assets and liabilities prior to the dissolution of a partnership. 7. Account for the sale of a partnership interest. 8. Account for the investment of a new partner in an existing partnership. 9. Account for the withdrawal of a partner from a partnership.

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Dissolution Step 1  Accounting records are closed.  Net income or net loss on the date of dissolution is recorded and transferred to the partners’ capital accounts. Step 2  Assets and liabilities are revalued at fair market value. Account for the revaluation of assets and liabilities prior to the dissolution of a partnership Objective 6

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Asset Revaluation  When transferred from one partnership to another assets are revalued to their fair market value.  The new value will not necessarily agree with the book value carried by the old firm.  The revaluation of assets affects the balance sheet only.

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An adjusting entry is prepared for the revalued items. GENERAL JOURNAL PAGE 4 DATE DESCRIPTION POST. DEBIT CREDIT REF. 20-- April 1 Merchandise Inventory 9000.00 Allow. for Doubtful Accounts 2300.00 Tom Lee Capital 2680.00 Joan Wilner Capital 2680.00 Nau Flores Capital 1340.00 To record revaluation of assets and allocation of gain to partners.

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There are two ways a new partner may be admitted to the partnership:  By purchasing all or part of the interest of an existing partner and paying that partner directly.  By investing cash or other assets directly in the existing partnership. Admission of a New Partner Account for the sale of a partnership interest Objective 7

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Account for the investment of a new partner in an existing partnership. Objective 8

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New Partner Given Credit for Amount Invested 20-- April 1 Cash 51500.00 Beth Rivera Capital 51500.00 To record investment of Rivera for one-fourth interest in partnership. New partner Rivera pays 51500 for ¼ interest in partnership.

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New Partner Given Credit for More Than Amount Invested After the cash investment is recorded a bonus is given to the new partner by crediting the new partner’s capital account. This credit is offset by debits to the original partners’ capital accounts. 20-- April 1 Tom Lee Capital 1800.00 Joan Wilner Capital 1800.00 Nau Flores Capital 900.00 Beth Rivera Capital 4500.00 To record bonus allowed new partner New partner paid 45500 for one-fourth interest in partnership. ¼ of partnership capital 50000

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If a new partner is given credit for less than the amount invested a bonus is allowed to the existing partners and is credited to their capital accounts in the former profit and loss ratio. 20-- April 1 Beth Rivera Capital 5500.00 Tom Lee Capital 2200.00 Joan Wilner Capital 2200.00 Nau Flores Capital 1100.00 To record bonus to original partners. New Partner Given Credit for Less Than Amount Invested

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When a partner withdraws the payment given to the withdrawing partner may be more or less than the withdrawing partner’s capital balance. The difference in the cash payment and the withdrawing partner’s capital account is debited or credited to the remaining partners according to their profit-and-loss ratio. Account for the withdrawal of a partner from a partnership Objective 9

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The revalued assets result in the following capital account balances: Lee 40980 Wilner 61180 Flores 52340 Total 154500 Withdrawal of Partner Paid the balance of her capital account. New Partner Given Credit for Amount Invested 20-- Mar. 31 Nau Flores Capital 52340.00 Cash 52340.00 To record cash payment made to Flores on withdrawal from partnership.

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Withdrawing Partner’s Capital Account  If the amount paid is higher than the withdrawing partner’s capital account balance the excess is debited to the capital accounts of the remaining partners according to their income and loss ratio.  If the amount paid is less than the withdrawing partner’s capital account balance the difference is credited to the remaining partners’ capital accounts based on their income and loss ratio.

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The revalued assets result in the following capital account balances: Lee 40980 Wilner 61180 Flores 52340 Total 154500 Withdrawal of Partner Paid more than the balance of her capital account. New Partner Given Credit for Amount Invested 20-- Mar. 31 Nau Flores Capital 52340.00 Tom Lee Capital 4500.00 Joan Wilner Capital 4500.00 Cash 61340 Flores receives a bonus of 61340- 52340 9000 The bonus comes out of the remaining partner’s capital accounts.

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Thank You