Advanced Financial Accounting 7e (Baker Lembre King).Chap015

8/7/2019 Advanced Financial Accounting 7e (Baker Lembre King).Chap015

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Partnerships

This chapter focuses on the formationand operation of partnerships, including

accounting for the addition of new partnersand the retirement of a present partner.

Chapter 16 presents the accounting fortermination and liquidation of partnerships.


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Partnerships

The number of partnerships in the UnitedStates has been estimated to be between

1.5 and 2.0 million, second only to soleproprietorships, which number in excessof 15 million businesses.

In contrast, there are about 1 millioncorporations in the United States.


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Partnerships

Partnerships are a popular form of businessbecause they are easy to form and becausethey allow several individuals to combinetheir talents and skills in a particular businessventure.


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Partnerships

In addition, partnerships provide a means of

obtaining more equity capital than a singleindividual can obtain and allow the sharing ofrisks for rapidly growing businesses.


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Partnerships

Accounting for partnerships requiresrecognition of several important factors.

First, from an accounting viewpoint, thepartnership is a separate business entity.

The Internal Revenue Code, however, views thepartnership form as a conduit only, notseparable from the business interests of theindividual partners.


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Partnerships

Second, although many partnerships accountfor their operations using accrual accounting,

some partnerships use the cash basis ormodified cash basis of accounting.

These alternatives are allowed because the

partnership records are maintained for thepartners and must reflect their informationneeds.


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Partnerships

The partnerships financial statements areusually prepared only for the partners, butoccasionally for the partnerships creditors.

Unlike publicly traded corporations, most

partnerships are not required to have annualaudits of their financial statements.


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Partnerships

Although many partnerships adhere to generallyaccepted accounting principles (GAAP),deviations from GAAP are found in practice.

The specific needs of the partners should be the

primary criteria for determining the accountingpolicies to be used for a specific partnership.


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Definition of a Partnership

Section 202 of the UPA 1997 states that, ...theassociation of two or more persons to carry on

as co-owners of a business for profit forms apartnership.... This encompasses three distinctfactors:

1. Association of two or more persons.

2. To carry on as co-owners.

3. Business for profit.


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Formation of a Partnership

The agreement to form a partnership may be asinformal as a handshake or as formal as a many

paged partnership agreement . Each partner must agree to the formation

agreement, and partners are strongly advisedto have a formal written agreement in order toavoid potential problems that may arise duringthe operation of the business.


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Partnership Formation

At the formation of a partnership, it is necessaryto assign a proper value to the non-cash assetsand liabilities contributed by partners.

An item contributed by a partner becomespartnership property.


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The partnership must clearly distinguishbetween capital contributions and loansmade to the partnership by individualpartners.


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Loan arrangements should be evidenced by

promissory notes or other legal documentsnecessary to show that a loan arrangementexists between the partnership and anindividual partner.


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The contributed assets should be valued attheir fair values, which may require appraisals

or other valuation techniques.

Liabilities assumed by the partnership should

be valued at the present value of the remainingcash flows.


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The individual partners must agree to thepercentage of equity that each will have in thenet assets of the partnership.

Generally, the capital balance is determined by

the proportionate share of each partners capitalcontribution.


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For example, if A contributes 70 percent of thenet assets in a partnership with B, then A willhave a 70 percent capital share and B will havea 30 percent capital share.


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In recognition of intangible factors, such as apartners special expertise or necessary

business connections, however, partners mayagree to any proportional division of capital.

Therefore, before recording the initial capitalcontribution, all partners must agree on thevaluation of the net assets and on eachpartners capital share.


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Other Major Characteristics of

Partnerships

After a state adopts the provisions of the UPA1997, all partnerships formed in that state areregulated by the act. Partnerships that do nothave a formal partnership agreement are alsoregulated by the UPA act of 1997.


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Limited Partnerships

Many persons view the possibility of personalliability for a partnerships obligations as a major

disadvantage of the general partnership form ofbusiness.

For this reason, sometimes people becomelimited partners in one of the several limited

partnership forms listed on the next slide:


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Limited Partnerships

Limited Partnership (LP): In a LP, there is atleast one general partner and one or more

limited partners. Limited Liability Partnerships (LLP): A LLP is

one which each partner has some degree ofliability shield

Limited Liability Limited Partnership (LLLP): Inmost states, a limited partnership may elect tobecome a limited liability limited partnership.


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Key Observations

Note that the partnership is an accounting entityseparate from each of the partners and that the

assets and liabilities are recorded at their marketvalues at the time of contribution.

No accumulated depreciation is carried forward

from the sole proprietorship to the partnership. All liabilities are recognized and recorded.


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Key Observations

The key point is that the partners may allocatethe capital contributions in any manner they

desire.

The accountant must be sure that all partners

agree to the allocation and must then record itaccordingly.


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Partners Accounts

The partnership may maintain several accountsfor each partner in its accounting records.

These partners accounts are as follows:

Capital Accounts.

Drawing Accounts.

Loan Accounts.


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Capital Accounts

The initial investment of a partner, anysubsequent capital contributions, profit or

loss distributions, and any withdrawals ofcapital by the partner are ultimately recordedin the partners capital account.

The balance in the capital account representsthe partners share of the net assets of thepartnership.


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Capital Accounts

Each partner has one capital account, whichusually has a credit balance.

On occasion, a partners capital account mayhave a debit balance, called a deficiency orsometimes termed a deficit, which occursbecause the partners share of losses andwithdrawals exceeds his or her capitalcontribution and share of profits.


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Capital Accounts

A deficiency is usually eliminated by additional

capital contributions.


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Drawing Accounts

Partners generally make withdrawals of

assets from the partnership during theyear in anticipation of profits.


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Drawing Accounts

A separate drawing account often is used to

record the periodic withdrawals and is thenclosed to the partners capital account atthe end of the period. For example:

Blue, Drawing $$$

Cash $$$


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Drawing Accounts

Noncash drawings should be valued at their fairmarket values (FMV)not book value (BV)at

the date of the withdrawal. For example:

Blue, Drawing FMV

Auto BV

Gain Difference*

*That is, FMV less BV


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Drawing Accounts

A few partnerships make an exception to therule of market value for withdrawals of inventory

by the partners.

They record withdrawal of inventory at cost,thereby not recording a gain or loss on thesedrawings.


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Loan Accounts

The partnership may look to its present partnersfor additional financing.

Any loans between a partner and thepartnership should always be accompanied byproper loan documentation such as promissorynote.

A loan from a partner is shown as a payable onthe partnerships books, the same as any otherloan.


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Loan Accounts

Unless all partners agree otherwise, thepartnership is obligated to pay interest on the

loan to the individual partner. Note that interest is not required to be paid on

capital investments unless the partnershipagreement states that capital interest is to be

paid.


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Loan Accounts

Interest on loans is recorded as an operating

expense by the partnership. Alternatively, the partnership may lend money

to a partner, in which case it records a loanreceivable from the partner.


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Loan Accounts

Again, unless it is otherwise agreed by all

partners, these loans should bear interest andthe interest income is recognized on thepartnerships income statement.


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Loan Accounts

A loan to/from a partner is a related-partytransaction for which separate footnote

disclosure is required, and it must be reportedas a separate balance sheet item, not includedwith other liabilities.


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Allocating Profit or Loss

Profit or loss is allocated to the partners atthe end of each period in accordance with

the partnership agreement.

If no partnership agreement exists, section 401of the UPA 1997 declares that profits and

losses are to be shared equally by allpartners.


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A wide range of profit distribution plans is found

in the business world. Some partnerships have straightforward

distribution plans, while others have extremelycomplex ones.


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It is the accountants responsibility to distribute

the profit or loss according to the partnershipagreement regardless of how simple or complexthat agreement is.

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Profit distributions are similar to dividendsfor a corporation: these distributions are not

included in the partnerships income statement,regardless of how profit is distributed.

Stated otherwise, profit distributions arerecorded directly into the partners capitalaccounts, not as expense items.

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Most partnerships use one or moreof the following distribution methods:

Preselected ratio.

Interest on capital balances.

Salaries to partners.

Bonuses to partners.

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Preselected Ratio

Preselected ratios are usually the result of

negotiations between the partners.

Some partnerships have different ratios if thefirm suffers a loss versus earns a profit.

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Preselected Ratio

Ratios for profit distributions may be based

on the percentage of total partnership capital,time and effort invested in the partnership, ora variety of other factors.

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Interest on Capital Balances

Distributing partnership income based oninterest on capital balances recognizes the

contribution of the partners capital investmentsto the profit-generating capacity of thepartnership.

This interest on capital is not an expense of thepartnership; it is a distribution of profits.

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Salaries to Partners

Section 401 of the UPA 1997 states that a

partner is not entitled to compensation forservices performed for the partnership except forreasonable compensation for services in windingup the business of the partnership.

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Salaries to Partners

If one or more of the partners services areimportant to the partnership, the profit

distribution agreement may provide for salariesor bonuses.

Again, these salaries paid to partners are a formof profit distribution and are not an expense ofthe partnership.

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Bonuses to Partners

Occasionally, the distribution process may

depend on the size of the profit or may differif the partnership has a loss for the period.

For example, salaries to partners might bepaid only if revenue exceeds expenses by acertain amount.

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Bonuses to Partners

The accountant must carefully read the

partnership agreement to determine the preciseprofit distribution plan for the specificcircumstances at the time.

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The profit or loss distribution is recorded with a

closing entry at the end of each period. The revenue and expenses are closed into an

income summary account or directly into thepartners capital accounts.

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In addition, the drawing accounts are closed tothe capital accounts at the end of the period.

An example is provided on the next two slides.

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Example: Allocating Profit or Loss

NOTE: All amounts assumed.

Blue, Capital $4,000

Blue, Drawing $4,000Close Blues drawing account.

Revenue $45,000

Expenses $35,000

Income Summary $10,000

Close revenue and expenses (assumingrevenue > expenses).

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Example: Allocating Profit or Loss

Income Summary $10,000

Alt, Capital $6,000Blue, Capital $4,000

Distribute profit in accordance with partnershipagreement (assuming 6:4 P/L ratio).

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Partnership Financial Statements

A partnership is a separate reporting entity

for accounting purposes, and the threefinancial statements - income statement,balance sheet, and statement of cash flows.

Typically are prepared for the partnership atthe end of each reporting period.

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Partnership Financial Statements

In addition to the three basic financial

statements, a statement of partners capitalis usually prepared to present the changes onthe partners capital accounts for the period.

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Changes in Membership

Changes in the membership of a partnership

occur with the addition of new partners ordissociation of present partners.

New partners are often a primary source ofadditional capital or needed business expertise.

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The legal structure of a partnership requires theadmission of a new partner to be subject to theunanimous approval of the present partners.

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Section 306 of the UPA 1997 states that a

person admitted as a new partner of an existingpartnership is not personally liable for anypartnership obligations incurred before the newpartner was admitted.

The retirement or withdrawal of a partner from apartnership is a dissociation of that partner.

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General concepts to account for a change in

membership in the partnership: The partnership is an entity separate from the

individual partners and use of GAAP

FASB 142, Goodwill and other intangible Assets.

FASB 144, Accounting for impairment of disposalof long-lived assets.

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A new partner may be admitted by:

Acquiring part of an existing partners interestdirectly in a private transaction with a sellingpartner.

Investing additional capital in the partnership.

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New Partner Purchases an Interest

An individual may acquire a partnership

interest directly from one or more of thepresent partners.

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In this type of transaction, cash or otherassets are exchanged outside the partner-ship, and the only entry necessary on thepartnerships books is a reclassification ofthe total capital of the partnership.

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The partnerships accountant should ensure that

sufficient evidence exists for any revaluation inorder to prevent valuation abuses.

Corroborating evidence such as appraisals or anextended period of excess earnings help supportasset valuations.

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New Partner Invests in Partnership

An investment less than the new partners

respective share indicates that the partnershipsprior net assets are overvalued. The alternativeaccounting treatment for this case are:

Revalue net assets downward.

Reduce previously recognized goodwill.

Allocate capital bonus to new partner.

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The bonus method realigns partners capitalsamong present and the new partner.

Recognizing valuation increases in net assets orgoodwill was not GAAP, but sometimes done bypartnerships not following GAAP.

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Generally, an excess of investment over the

respective book value of the new partner interestindicates that the partnerships prior net assetsare undervalued or that the partnership hassome unrecorded goodwill.

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Three alternative accounting treatments exist in

this case:

Revalue net assets upward.

Record unrecognized goodwill.

Allocate capital bonus to current partners.

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With respect to the three alternatives indicated in

the prior slide, the decision is usually a result ofnegotiations between the prior partners and theprospective partner.


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Dissociation of a Partner

When a partner retires or withdraws from a

partnership. In most cases, the partnershippurchases the dissociated partners interest inthe partnership for a buyout price.

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Section 701 of UPA 1997 states that the buyout

price is the estimated amount if the net assets ofthe partnership had been sold at a price equal tothe greater of the liquidation value or the valuebased on a sale of the entire business as a

going concern without the dissociated partner.

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Goodwill may be included in the valuation.

The partnership must pay interest to the

dissociated partner from the date of dissociationto the date of settlement.

In cases of wrongful dissociation, the partnershipmay sue the withdrawing partner for damages

the wrongful dissociation causes thepartnership.

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In the case in which the partnership agrees tothe dissociation and it is not wrongful, the

accountant can aid in the computation of thebuyout price.

The partnership agreement may include otherprocedures to use in the case of a partner

dissociation.

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Some partnerships have an audit performed

when a change in partners is made. This auditestablishes the accuracy of the existence andbook values of the assets and liabilities.

Generally, the existing partners buy out the

retiring partners interest.

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For example, assume that Alt retires from theABC Partnership when his capital account has a

balance of $55,000, after recording all increasesin the partnerships net assets including incomeearned up to the date of retirement.

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All partners agree to the $55,000 as the buyout

price of Alts partnership interest. The entrymade by the ABC Partnership is:

Alt, Capital $55,000

Cash $55,000Retirement of Alt.

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Alt has a capital credit of $55,000 and all

partners agree to a buyout price of $65,000. Most partnerships account for the $10,000

payment above Alts capital credit as a capitaladjustment bonus to Alt from the capital

accounts of the remaining partners.

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Sometimes, the buyout price is less than apartners capital credit.

For example, Alt agrees to accept $50,000 asthe buyout price for his partnership interest.

If no revaluations of the net assets is necessary,then the $5,000 difference is distributed as a

capital adjustment to remaining partners basedupon their profit and loss ratio.

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Tax Aspects of a Partnership

The Internal Revenue Service views thepartnership form of organization as a temporaryaggregation of the individual partners rights.

The partnership is not a separate taxable entity.

Therefore, the individual partners must reporttheir share of the partnership income or loss ontheir personal tax returns, whether withdrawn ornot.

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Partnership Joint Venture

A partnership joint venture is accountedfor as any other partnership.

Typically, the joint venture has its ownaccounting records, and all facets ofpartnership accounting presented in

this chapter apply to these partnerships.

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Partnership Joint Venture

Some joint ventures are accounted for on the

books of one of the venturers; however, thiscombined accounting does not fully reflect thefact that the joint venture is a separate reportingentity.

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You Will Survive This Chapter !!!

The Uniform Partnership Act of 1997, and the

specific terms of the articles of partnership,dictate partnership accounting procedures.


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Partnerships: Formation, Operation, and Changes in Membership

End of Chapter

Advanced Financial Accounting 7e (Baker Lembre King).Chap015

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