advanced accounting 6e by jeter chaney chapter 15

Advanced Accounting

Jeter ● Chaney

Partnerships: Formation, Operation
and Ownership Changes

1

Prepared by Sheila Ammons, Austin Community College


Learning Objectives

•
•
•

Describe the characteristics of a general partnership, a limited partnership, and a joint venture.

•
•

Explain the purpose of the partners’ drawing accounts and capital accounts.

List some important items to be included in the partnership agreement.
Understand the differences between partnerships’ and corporations’ equity accounts in the
balance sheet.
Prepare journal entries to form a partnership using the bonus and the goodwill methods.

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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Learning Objectives

•
•

Describe some common agreements used to allocate partnership net income or loss.
Explain why salary allowances and interest allowances are used in allocating partnership profits
and losses.

•

Describe the methods used to record partnership changes when a new partner is admitted or
when a partner withdraws from the partnership.

•

Describe the rationale behind the goodwill method in accounting for changes in partnership
membership.

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Partnership Defined

•
•

“An association of two or more persons to carry on as co-owners a business for profit.”*

– Persons in this definition include individuals, partnerships, corporations, and other
associations.

Attributes:

– Agreement, expressed or implied.
– Operated for making a profit.
– Members must be co-owners.
*Uniform Partnership Act (UPA), Section 6

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Reasons for Forming a Partnership

•

Advantages of a partnership:

– Permits pooling of capital and other resources without complexities and formalities of a
corporation.

– Easier and less costly to establish than a corporation.
– Not subject to as much governmental regulation as a corporation.
– Partners able to operate with more flexibility.
– Income not subject to taxation at partnership level.

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Characteristics of a Partnership

•

One distinctive characteristic of a partnership is its advantageous federal income treatment.

– A partnership is treated as a “flow through” entity.
• Income is not subject to taxation at the partnership level.
– A partnership must file an information return with the IRS.
• Income or loss is allocated to the individual partners.
– A partner’s share of the income or loss is reported on his or her individual income tax
return.

• Whether distributed by the partnership or not.

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LO 1 Characteristics of a general partnership.
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Characteristics of a Partnership
General Partnership

•
•

Each member is a general partner.
Characteristics:

– Mutual Agency
– Right to Dispose of Partnership Interest
– Unlimited Liability
– Limited or Uncertain Life

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LO 1 Characteristics of a general partnership.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Characteristics of a Partnership
Limited Partnership
At least one general partner and one limited partner.

General Partner(s)

Limited Partner(s)

Manage the firm.

Invest capital only.

Liable for obligations.

Limited liability.
No participation in management.

Allows general partners to raise capital without giving up management control.

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LO 1 Characteristics of a limited partnership.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Characteristics of a Partnership
Joint Ventures

•

•

Arrangement by two or more parties to accomplish a single or limited purpose for their mutual
benefit.

– Life limited to that of the undertaking.
– Relationship governed by written agreement.
– Each party participates in overall management.
– Commonly organized as corporations or partnerships.

In general, partnership law applies to a partnership joint venture, but

– The authority of a joint venturer is limited to a greater extent than that of a general partner.

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LO 1 Characteristics of a joint venture.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.

Partnership Agreement

•

Agreement should include the following:

– Name of the firm and identity of the partners.
– Nature, purpose, and scope of the business.
– Effective date of organization.
– Length of time partnership is to operate.
– Location of place of business.
– Provision for allocation of profit and loss.
– Provision for salaries and withdrawals by partners.
– Rights, duties, and obligations of each partner.
– Authority of each partner in contract situations.

10
LO 2 Important items in a partnership agreement.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Partnership Agreement

•

Agreement should include the following:

– Procedures for admitting a new partner.

– Procedures on withdrawal or death of a partner.
– Procedures for arbitration of disputes.
– Fiscal period of partnership.
– Identification and valuation of initial asset investments and capital interest.
– Situations for partnership dissolution and provisions for terminating or continuing the
business.

– Accounting practices to be followed.
– Whether or not an audit is to be performed.

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LO 2 Important items in a partnership agreement.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Partnership Agreement

•

Capital Interest versus Profit Interest

– Capital Interest - claim against the net assets of the partnership as shown by the balance in
the partner’s capital account.

– Interest in Income and Loss - how partner’s capital interest will increase or decrease as a
result of subsequent operations.

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LO 2 Important items in a partnership agreement.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.

Accounting for a Partnership
Partnerships basically adhere to GAAP.



This text assumes GAAP-based partnership accounting.

Small or specialized partnerships may utilize either



Cash basis or



Tax basis accounting.

Partners’ interest in net income or loss may not be proportional to their respective capital interests.

LO 3 Partnerships’ equity versus shareholders’13equity.
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Accounting for a Partnership

•

Partnerships equity section normally consists of:

– Capital account
• Generally, investments and withdrawals of assets considered to be other than
temporary are recorded in the capital account.

– Drawing account
• Typically debited to record withdrawals of assets in anticipation of profitable

operations or payments of personal expenses of a partner from partnership assets.

– Closed periodically to the capital account.

One capital and one drawing account for each partner.
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LO 4 Drawing and capital accounts.
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Accounting for a Partnership
Exercise 15-2: Tom and Julie formed a management consulting partnership on January 1, 2014. The fair value of the net
assets invested by each partner follows:
Tom
Cash

Julie

$13,000

$12,000

Accounts receivable

8,000

6,000

Office supplies

2,000

800

30,000

—

—

30,000

Accounts payable

2,000

5,000

Mortgage payable

—

18,800

Office equipment
Land

During the year, Tom withdrew $15,000 and Julie withdrew $12,000. Net profit for 2014 was $50,000, which is to be allocated
based on the original net capital investment.

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LO 5 Recording the formation of a partnership.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Accounting for a Partnership
Exercise 15-2: A(1). Prepare journal entries to record the initial investment in the partnership for Tom.

Cash

13,000

Accounts receivable

8,000

Office supplies

2,000

Office equipment

30,000

Accounts payable

2,000

Tom, Capital

51,000

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LO 5 Recording the formation of a partnership.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Accounting for a Partnership
Exercise 15-2: A(1). Prepare journal entries to record the initial investment in the partnership for Julie.

Cash

12,000

Accounts receivable

6,000

Office supplies
Land

800

30,000
Accounts payable

5,000

Mortgage payable

18,800

Julie, Capital

25,000

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LO 5 Recording the formation of a partnership.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Accounting for a Partnership
Exercise 15-2: A(2). Record the withdrawals.

Tom, Drawing

15,000

Cash

15,000

Julie, Drawing

12,000

Cash

12,000

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LO 5 Recording the formation of a partnership.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Accounting for a Partnership
Exercise 15-2: A(3). Close the Income Summary and Drawing accounts.

Income Summary

50,000

Tom, Capital

33,553

Julie, Capital

16,447

50,000 x (51,000/76,000) = 33,553
50,000 x (25,000/76000) = 16,447

Tom, Capital

15,000

Tom, Drawing

15,000

Julie, Capital

12,000

Julie, Drawing

12,000
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LO 5 Recording the formation of a partnership.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Accounting for a Partnership
Allocation of Net Income or Net Loss

•
•

Partnership agreement should indicate how income and losses are allocated.

– The objective of the profit and loss agreement should be to reward the individual partners

for their contributions of resources to the partnership.

Based on:

– Fixed ratio.
– Ratio based on capital balances.
– Interest on capital investment.
– Fixed salary allocation.
– Bonus as a percentage of income.

LO 6 Allocating net income20or loss.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Accounting for a Partnership

•

Exercise 15-5: On January 1, 2014, Tony and Jon formed T&J Personal Financial Planning
with capital investments of $480,000 and $340,000, respectively. The partnership agreement
provides that profits are to be allocated as follows:

1)
2)

•

3)
4)

Annual salaries of $42,000 and $66,000 are granted to Tony and Jon, respectively.
Jon is entitled to a bonus of 10% of net income after salaries and bonus but before
interest on capital investments is subtracted.
Each partner is to receive an interest credit of 8% on the original capital investment.
Remaining profits are allocated 40% to Tony and 60% to Jon.

On December 31, 2014, the partnership reported net income before salaries, interest, and bonus
of $188,000.

LO 6 Allocating net income21or loss.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Accounting for a Partnership
Exercise 15-5: Calculate the 2014 allocation of partnership bonus.

Bonus Calculation

Bonus
LO 6 Allocating net income22or loss.
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Accounting for a Partnership
Exercise 15-5: Calculate the 2014 allocation of partnership profit of $188,000.
Tony
Salary

Jon

Total

$42,000

$66,000

$108,000

0

7,273

7,273

Interest on capital

38,400

27,200

65,600

Total

80,400

100,473

180,873

2,851

4,276

7,127

$83,251

$104,749

$188,000

Bonus (previous slide)

Remainder (40%/60%)
Income allocation

LO 6 Allocating net income23or loss.
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Accounting for a Partnership
Insufficient Income to Cover Allocation
Amount by which salary and/or interest exceeds net income is allocated to individual partners in their
agreed ratio for allocating residual income.

For example, assume that Adams and Brown agree to divide profits as follows:

1.Salary: Adams, $4,000; Brown, $2,000
2.Interest: 8% on average capital balances - Adams, $77,500;

3.Remainder: To be divided equally

Brown, $37,500

LO 6 Allocating net income24or loss.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Accounting for a Partnership
Insufficient Income to Cover Allocation
Amount by which salary and/or interest exceeds net income is allocated to individual partners in their
agreed ratio for allocating residual income.

LO 6 Allocating net income25or loss.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.