Principles of financial accounting 12e by needles crosson chapter 12

CHAPTER

12

Accounting for Partnerships

Principles of
Accounting
12e
Needles
Powers
Crosson
©human/iStockphoto


Concepts Underlying Partnerships
 A partne rs hip, as defined by the Uniform
Partnership Act, is an association of two or
more persons to carry on as co-owners of a
business for profit.
– Partnerships are treated as s e parate e ntitie s , with
their own accounting records and financial
statements.
– Legally, there is no economic separation between
a partnership and its owners.

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Characteristics of Partnerships
(slide 1 of 3)

 Voluntary association—A partnership is a voluntary
association of individuals. Therefore, a partner is
legally responsible for his or her partners’ actions
within the scope of the business.
 Partnership agreement—Although not required, it is
good business practice to have a written
partne rs hip ag re e me nt that clearly states:
–
–
–
–
–

Name, location, and purpose of the business
Names of the partners and their respective duties
Investments of each partner
Method of distributing income and losses
Procedures for the admission and withdrawal of partners,
the withdrawal of assets, and the liquidation of the business

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Characteristics of Partnerships
(slide 2 of 3)

 Limited life—A partnership has a limite d life . It may
be dissolved when:
– a new partner is admitted

– a partner withdraws, goes bankrupt, is incapacitated,
retires, or dies
– the terms of the partnership agreement are met, such as
when the project for which the partnership was formed is
completed

 Mutual agency—Each partner is an agent of the
partnership within the scope of the business.
Because of this mutual ag e nc y, any partner can
bind the partnership to a business agreement as
long as he or she acts within the scope of the
company’s normal operations.
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Characteristics of Partnerships
(slide 3 of 3)

 Unlimited liability—Each partner has personal
unlimite d liability for all the debts of the
partnership. If the assets of the business are not
enough to pay all the debts of the business, creditors
can seek payment from the personal assets of each
partner.
 Co-ownership of partnership property—When
individuals invest property in a partnership, the
property becomes an asset of the partnership and is
owned jointly by the partners.
 Participation in partnership income—Each partner
has the right to share in the partnership’s income

and the responsibility to share in its losses.
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Advantages and Disadvantages of
Partnerships
 Advantages
– Can be easy to form,
change, and dissolve.
– Facilitates the pooling of
capital resources and
individual talents.
– Has no corporate tax
burden.
– Gives the partners a
certain amount of
freedom and flexibility.

 Disadvantages
– The life of a partnership
is limited.
– One partner can bind the
partnership to a contract.
– Partners have unlimited
personal liability.
– It is more difficult for a
partnership to raise
capital than it is for a
corporation.

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Accounting for Partners’ Equity
 Accounting for a partnership is similar to
accounting for a sole proprietorship, but there
are differences.
– Owner’s equity in a partnership is called partne rs ’
e quity.
– It is necessary to divide the income and losses of
the company between the partners.
– It is necessary to maintain separate Capital and
Withdrawals accounts for each partner.

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Distribution of Partnership Income and Losses
 A partnership’s income and losses can be distributed
according to whatever method the partners specify in
the partnership agreement.
– If the agreement does not specify this, the
partners share income and losses equally.
– Income in a partnership normally has three
components:
 Return to the partners for the use of their capital (called
inte re s t on partne rs ’ capital)
 Compensation for services the partners have rendered
 Other income for any special contributions individual
partners may make to the partnership or for risks they

may take
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Stated Ratios
 One method of distributing income and
losses is to give each partner a stated ratio of
the total income or loss.
– If each partner is making an equal contribution to
the firm, each can assume the same share of
income and losses.
– An equal contribution does not necessarily mean
an equal capital investment, because one partner
may be devoting more time and another partner
more capital.
– If the partners contribute unequally to the firm,
unequal stated ratios can be appropriate.
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Capital Balance Ratios
 Income and losses may be distributed
according to capital balances.
 The ratio used may be based on each
partner’s capital balance at the beginning of
the year or on the average capital balance of
each partner during the year.

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Salaries, Interest, and Stated Ratios
 To make up for unequal contributions to a
firm, a partnership agreement can allow for
partners’ salaries, interest on partners’ capital
balances, or both in the distribution of
income.
– Salaries and interest of this kind are not deducted
as expenses before the partnership income is
determined.

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Dissolution of a Partnership
 Dis s o lutio n of a partnership occurs whenever there
is a change in the original association of partners.
– When a partnership is dissolved, the partners lose
their authority to continue the business as a going
conce rn.
– This does not mean that the business operation
necessarily is ended or interrupted, but from a
legal standpoint, the separate entity ceases to
exist.
– The dissolution may take place through the
admission of a new partner, the withdrawal of a
partner, or the death of a partner.
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Admission of a New Partner
 The admission of a new partner dissolves the
old partnership because a new association
has been formed.
– Dissolving the old partnership and creating a new
one requires the consent of all the original
partners and the ratification of a new agreement.
– An individual can be admitted to a partnership in
one of two ways:
 Purchasing an interest in the partnership from one or
more of the original partners
 Investing assets in the partnership

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Bonus to the Old Partners
 A new investor is sometimes willing to pay
more than the actual dollar interest he or she
receives in the partnership.
 The excess of the payment over the interest
purchased is a bo nus to the original
partners.
– The bonus must be distributed to the original
partners according to the partnership agreement
or, if the agreement does not cover the
distribution of bonuses, in accordance with the
method for distributing income and losses.
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Bonus to the New Partner
 A partnership might want a new partner for
several reasons.
– A partnership in financial trouble might need
additional cash, or the partners might want to
expand the firm’s markets and need more capital.
– The partners might also know a person who
would bring a unique talent to the firm.
– Under these conditions, part of the original
partners’ capital may be transferred to the new
partner’s Capital account as a bonus.

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Withdrawal of a Partner
 Generally, a partner has the right to withdraw
from a partnership in accord with legal
requirements.
– The partnership agreement should describe the
procedures to be followed, including:





Whether an audit will be performed
How the assets will be reappraised
How a bonus will be determined

By what method the withdrawing partner will be paid

– A partner can withdraw from a partnership in one
of several ways.
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Withdrawal Not Equal to Capital Balance
 A partner’s withdrawal is not always equal to the that
partner’s capital account.
– When a withdrawing partner removes assets that
are less than his or her capital balance, the equity
that the partner leaves in the business is divided
among the remaining partners according to their
stated ratios.
– When a withdrawing partner takes out assets that
are greater than his or her capital balance, the
excess is treated as a bonus to the withdrawing
partner. The remaining partners absorb the bonus
by reducing their capital accounts according to
their stated ratios.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Death of a Partner
 When a partner dies, the partnership is
dissolved because the original association
has changed.
– Normally the books are closed, and financial
statements are prepared to determine the capital

balance of each partner on the date of death.
– The remaining partners may purchase the
deceased’s equity, sell it to outsiders, or deliver
certain business assets to the estate of the
deceased partner.
– If the firm intends to continue, a new partnership
must be formed.
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Liquidation of a Partnership
 The liquidatio n of a partnership is the
process of selling enough assets to pay the
partnership’s liabilities and distributing any
remaining assets among the partners.
– Liquidation is a form of dissolution.
– As the assets of the business are sold, any gain
or losses should be distributed according to the
stated ratios.
– As cash becomes available, it must be applied
first to outside creditors, then to loans from
partners, and finally to the partners’ capital
balances.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Limited Partnerships
 A limite d partne rs hip (LP) is a special type
of partnership that, like corporations,
confines the limited partner’s potential loss to

the amount of his or her investment in the
business.
– Under this type of partnership, the unlimited
liability disadvantage can be overcome.
– Usually, the limited partnership has a general
partner who has unlimited liability but allows other
partners to limit their potential loss.

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Joint Ventures
 A jo int ve nture is an association of two or
more entities for the purpose of achieving a
specific goal, such as the manufacture of a
product in a new market.
– Most joint ventures have an agreed-upon limited
life.
– Profits and losses are shared on an agreed-upon
basis.
– J oint ventures frequently take the form of
partnerships between two or more corporations
and other investors.
– They are often used by U.S. companies that want

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Companies That Look Like Partnerships
 S c o rpo ratio ns —corporations that U.S. tax laws

treat as partnerships
– Unlike normal corporations, they do not pay federal income
taxes.
– They have a limited number of stockholders, who report the
income or losses on their investments in the business on
their personal tax returns.

 Limite d liability c o mpany (LLC)—companies
whose members are partners, but their liability is
limited to their investment in the business
 S pe c ial-purpo s e e ntitie s (S PEs )—firms with limited
lives that a company creates to achieve a specific
objective, such as raising money by selling
receivables
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.