Chapter 15

1. Chapter 15 Partnerships: Formation, Operation, and Changes in Membership

2. Partnerships • This chapter focuses on the formation and operation of partnerships, including accounting for the addition of new partners and the retirement of a present partner. • Chapter 16 presents the accounting for termination and liquidation of partnerships.

3. Partnerships • The number of partnership in the United States has been estimated to be between 1.5 and 2.0 million, second only to sold proprietorships, which number in excess of 15 million businesses. • In contrast, there are about 1 million corporations in the United States.

4. Partnerships • Partnerships are a popular form of business because they are easy to form and because they allow several individuals to combine their talents and skills in a particular business venture. • In addition, partnerships provide a means of obtaining more equity capital than a single individual can obtain and allow the sharing of risks for rapidly growing businesses.

5. Partnerships • Accounting for partnerships requires recognition of several important factors. • First, from an accounting viewpoint, the partnership is a separate business entity. • From a legal viewpoint, however, a partnership, like a sole proprietorship, is not separate from the owners.

6. Partnerships • Second, although many partnerships account for their operations using accrual accounting, some partnerships use the cash basis or modified cash basis of accounting. • These alternatives are allowed because the partnership records are maintained for the partners and must reflect their information needs.

7. Partnerships • The partnership’s financial statements are usually prepared only for the partners, but occasionally for the partnership’s creditors. • Unlike publicly traded corporations, most partnerships are not required to have annual audits of their financial statements.

8. Partnerships • Although many partnerships adhere to generally accepted accounting principles (GAAP), deviations from GAAP are found in practice. • The specific needs of the partners should be the primary criteria for determining the accounting policies to be used for a specific partnership.

9. Definition of a Partnership • The Uniform Partnership Act of 1914 (UPA) has been the general governing authority for partnerships since its adoption by almost all the states. • Section 6 of the UPA defines a partnership as an “association of two or more persons to carry on as co-owners a business for profit.”

10. Formation of a Partnership • The agreement to form a partnership may be as informal as a handshake or as formal as a many paged agreement typically termed the articles of copartnership. • Each partner must agree to the formation agreement, and partners are strongly advised to have a formal written agreement in order to avoid potential problems that may arise during the operation of the business.

11. Limited Life • A partnership legally terminates as a business entity each time there is a change in membership. • This legal termination is called a “dissolution of partnership.” • Most partnerships include provisions in their articles of copartnership for changes in membership so that the business is not interrupted.

12. Agency Relationship • Each partner is a co-owner of the partnership assets and liabilities. • Creditors view each partner as an agent of the partnership capable of transacting business in the name of the partnership. • Consequently, any partner can bind the partnership when acting within the scope of the partnership activities.

13. Unlimited Liability • Because partnerships are not incorporated, all partners in a general partnership have unlimited liability. • In the event the partnership fails and its assets are not sufficient to pay its liabilities, partnership creditors may take recourse by obtaining liens or attachments against the personal assets of any or all the partners. • Generally, creditors will take action against the partner with the most liquid assets.

14. Limited Partnership • Many persons view unlimited liability as the major disadvantage of partnership form of business. • For this reason, sometimes people become limited partners in a limited partnership. • The liability of limited partners is limited to the amount of their investment, but they are restricted as to the types of management acts they may perform.

15. Limited Liability Partnership • Many public accounting and other professional service partnerships now have letters LLP after the name of their partnership. • The LLP means that the partnership is limited liability partnership, registered as such under appropriate state laws. • This designation has not changed the nature of accounting services provided to clients and has been generally accepted in the business place.

16. Limited Liability Partnership • The limited liability partnership is a recent change in the partnership law or most states and provides that the partners are not personally liable for any debt, obligation, or liability that is chargeable to the partnership. • The partners are still liable up to the amount of their capital accounts, but their personal assets are protected from the partnership’s creditors.

17. Partnership Formation • At the formation of a partnership, it is necessary to assign a proper value to the non-cash assets and liabilities contributed by partners. • An item contributed by a partner becomes partnership property co-owned by all partners.

18. Partnership Formation • The partnership must clearly distinguish between capital contributions and loans made to the partnership by individual partners. • Loan arrangements should be evidenced by promissory notes or other legal documents necessary to show that a loan arrangement exists between the partnership and an individual partner.

19. Partnership Formation • The contributed assets should be valued at their fair values, which may require appraisals or other valuation techniques. • Liabilities assumed by the partnership should be valued at the present value of the remaining cash flows.

20. Partnership Formation • The individual partners must agree to the percentage of equity that each will have in the net assets of the partnership. • Generally, the capital balance is determined by the proportionate share of each partner’s capital contribution. • For example, if A contributes 70 percent of the net assets in a partnership with B, then A will have a 70 percent capital share and B will have a 30 percent capital share.

21. Partnership Formation • In recognition of intangible factors, such as a partner’s special expertise or necessary business connections, however, partners may agree to any proportional division of capital. • Therefore, before recording the initial capital contribution, all partners must agree on the valuation of the net assets and on each partner’s capital share.

22. Key Observations • Note that the partnership is an accounting entity separate from each of the partners and that the assets and liabilities are recorded at their market values at the time of contribution. • No accumulated depreciation is carried forward from the sole proprietorship to the partnership. • All liabilities are recognized and recorded.

23. Key Observations • The key point is that the partners may allocate the capital contributions in any manner they desire. • The accountant must be sure that all partners agree to the allocation and must then record it accordingly.

24. Partner’s Accounts • The partnership may maintain several accounts for each partner in its accounting records. • These partner’s accounts are as follows: • Capital Accounts. • Drawing Accounts. • Loan Accounts.

25. Capital Accounts • The initial investment of a partner, any subsequent capital contributions, profit or loss distributions, and any withdrawals of capital by the partner are ultimately recorded in the partner’s capital account. • The balance in the capital account represents the partner’s share of the net assets of the partnership.

26. Capital Accounts • Each partner has one capital account, which usually has a credit balance. • On occasion, a partner’s capital account may have a debit balance, called a deficiency or sometimes termed a deficit, which occurs because the partner’s share of losses and withdrawals exceeds his or her capital contribution and share of profits. • A deficiency is usually eliminated by additional capital contributions.

27. Drawing Accounts • Partners generally make withdrawals of assets from the partnership during the year in anticipation of profits. • A separate drawing account often is used to record the periodic withdrawals and is then closed to the partner’s capital account at the end of the period. For example: Blue, Drawing $$$ Cash $$$

28. Drawing Accounts • Noncash drawing should be valued at their fair market 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

29. Drawing Accounts • A few partnerships make an exception to the rule 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 these drawings.

30. Loan Accounts • The partnership may look to its present partners for additional financing. • Any loans between a partner and the partnership should always be accompanied by proper loan documentation such as promissory note. • A loan from a partner is shown as a payable on the partnership’s books, the same as any other loan.

31. Loan Accounts • Unless all partners agree otherwise, the partnership 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 partnership agreement states that capital interest is to be paid. • Interest on loans is recorded as an operating expense by the partnership.

32. Loan Accounts • Alternatively, the partnership may lend money to a partner, in which case it records a loan receivable from the partner. • Again, unless it is otherwise agreed by all partners, these loans should bear interest and the interest income is recognized on the partnership’s income statement.

33. Loan Accounts • A loan to/from a partner is a related-party transaction for which separate footnote disclosure is required, and it must be reported as a separate balance sheet item, not included with other liabilities.

34. Allocating Profit or Loss • Profit or loss is allocated to the partners at the end of each period in accordance with the partnership agreement. • If no partnership agreement exists, section 18 of the UPA declares that profits and losses are to be shared equally by all partners.

35. Allocating Profit or Loss • A wide range of profit distribution plans is found in the business world. • Some partnerships have straightforward distribution plans, while others have extremely complex ones. • It is the accountant’s responsibility to distribute the profit or loss according to the partnership agreement regardless of how simple or complex that agreement is.

36. Allocating Profit or Loss • Profit distributions are similar to dividends for a corporation: these distributions should not be included in the income statement, regardless of how profit is distributed. • Stated otherwise, profit distributions are recorded directly into the partner’s capital accounts, not as expense items.

37. Allocating Profit or Loss • Most partnerships use one or more of the following distribution methods: • Preselected ratio. • Interest on capital balances. • Salaries to partners. • Bonuses to partners.

38. Preselected Ratio • Preselected ratios are usually the result of negotiations between the partners. • Ratios for profit distributions may be based on the percentage of total partnership capital, time and effort invested in the partnership, or a variety of other factors. • Some partnerships have different ratios if the firm suffers a loss versus earns a profit.

39. Interest on Capital Balances • Distributing partnership income based on interest on capital balances recognizes the contribution of the partners’ capital investments to the profit-generating capacity of the partnership. • This interest on capital is not an expense of the partnership; it is a distribution of profits.

40. Salaries to Partners • If one or more of the partners’ services are important to the partnership, the profit distribution agreement may provide for salaries or bonuses. • Again, these salaries paid to partners are a form of profit distribution and are not an expense of the partnership.

41. Bonuses to Partners • Occasionally, the distribution process may depend on the size of the profit or may differ if the partnership has a loss for the period. • For example, salaries to partners might be paid only if revenue exceeds expenses by a certain amount. • The accountant must carefully read the articles of copartnership to determine the precise profit distribution plan for the specific circumstances at the time.

42. Allocating Profit or Loss • 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 the partners’ capital accounts. • In addition, the drawing accounts are closed to the capital accounts at the end of the period. • An example is provided on the next two slides.

43. Example: Allocating Profit or Loss • NOTE: All amounts assumed. • Blue, Capital $4,000 Blue, Drawing $4,000 Close Blue’s drawing account. • Revenue $45,000 Expenses $35,000 Income Summary $10,000 Close revenue and expenses (assuming revenue > expenses).

44. Example: Allocating Profit or Loss • Income Summary $10,000 Alt, Capital $6,000 Blue, Capital $4,000 Distribute profit in accordance with partnership agreement (assuming 6:4 P/L ratio).

45. Partnership Financial Statements • A partnership is a separate reporting entity for accounting purposes, and the three financial statements - income statement, balance sheet, and statement of cash flows– typically are prepared for the partnership at the end of each reporting period. • In addition to the three basic financial statements, a statement of partners’ capital is usually prepared to present the changes on the partners’ capital accounts for the period.

46. Changes in Membership • Changes in the membership of a partnership occur with the addition of new partners or retirement of present partners. • New partners are often a primary source of additional capital or needed business expertise. • The legal structure of a partnership requires the admission of a new partner to be subject to the unanimous approval of the present partners.

47. Changes in Membership • Public announcements are typically made about new partner additions so that third parties transacting business with the partnership are aware of the change in the partnership. • A new partner is liable for all obligations of the partnership incurred before the new partner’s admission date, but the extent of liability for preexisting debts is limited to the new partner’s capital investment.

48. Changes in Membership • The retirement or withdrawal of a partner from a partnership results in the legal dissolution of the partnership. • A dissolution does not require termination of the business. • A dissolution means that the partnership’s books are brought up to date through any necessary adjusting entries and the withdrawing partner’s capital account is determined as of the date of withdrawal.

49. Changes in Membership • The admission of a new partner or retirement of a present partner results in a new partnership, although daily operations of the business generally are not affected. • Because a new partnership is formed, many partnerships use the transactions surrounding the change as evidence for revaluing the existing assets of the partnership or for recording previously unrecognized goodwill.

50. Changes in Membership • This practice of asset revaluation and goodwill recognition constitutes a marked difference from corporation practice. • The justification given to revaluing assets at the time of the change in the membership of the partnership is to state fully the true economic condition of the partnership at the time of the change in membership and to assign the changes in asset values and goodwill to the partners who have been managing the business during the time the changes in values occurred.