Partnerships: Formation, Operation, and Changes in Membership

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

2. Learning Objective 1 Understand and explain the nature and regulation of partnerships.

3. A B ABC Company What is a Partnership? • An association of two or more persons who • are co-owners of a business, and • share profits and losses in an agreed-upon manner.

4. What is a “Person”? • An individual • A corporation • Another partnership Z Corp T&D Partnership

5. Partnerships: Pros & Cons • Advantages • Ease of formation • Lack of formality • Single taxation (see following slide) • Disadvantages • Unlimited liability (for general partnerships) • Difficulty in disposing of partnership interests • Mutual agency

6. Single Taxation of Partnership Earnings Partnerships only report their earnings—they are not taxed at the business entity level (as are corporations). Partnerships file IRS Form 1065, which shows the allocation of profits among partners. Partners report their share of profits on their individual IRS Form 1040 return. Partnership Form of Organization: Income Tax Reporting Uncle Sam A B AB Partnership

7. Regulation • Each state regulates the partnerships that are formed in it. • Most states begin with a model act and then modifies it to fit that state’s business culture and history. • Most have now adopted the Uniform Partnership Act of 1997 (UPA 1997) as their model act.

8. The UPA 1997 covers: Relations of partners to one another. Relations of partners to persons dealing with the partnership. Dissolution and winding up of the partnership. Regulation: The Uniform Partnership Act (UPA)

9. What is a partnership agreement? A written expression of what the partners have agreed to. Examples of areas addressed: Manner of sharing profits. Limitations on withdrawals. Rights of partners. Settling with withdrawing partners. Expulsion of partners. Conflicts of interest. The Partnership Agreement

10. Practice Quiz Question #1 Which of the following is not one of the advantages of general partnerships? • Ease of formation • Unlimited liability • Lack of formality • Single taxation

11. Practice Quiz Question #1 Solution Which of the following is not one of the advantages of general partnerships? • Ease of formation • Unlimited liability • Lack of formality • Single taxation

12. Learning Objective 2 Understand and explain the differences among different types of partnerships.

13. Types of Partnerships • General Partnerships • All partners have unlimited liability. • Creditors can go after the personal assets of any or all of the partners.

14. Types of Partnerships • Limited Partnerships • Limited partners have limited liability to partnership creditors if the partnership is unable to pay its debts. • Limited partners’ risk is limited to their invested capital. • Thus, personal assets are not at risk. • At least one of the partners must be a general partner.

15. Types of Partnerships • Limited Liability Partnerships (LLPs) • A partner’s personal assets are at risk only for • his or her ownnegligence and wrongdoing, • the negligence and wrongdoing of those under his or her control, but • not debts. • Since 1993, many accounting firms have changed from general partnerships to LLPs.

16. Types of Partnerships • Limited Liability Limited Partnerships (LLLPs) • Like a limited partnership, must have at least one general partner. • General partners manage the partnership. • Big difference relates to the liability of general partners: • No personal liability for partnership obligations (like a limited partner) • Not liable for wrongdoing of other partners—just personal decisions and decisions of those supervised

17. Practice Quiz Question #2 Which of the following statements is true? The partners in a general partnership have limited liability. At least two of the partners in a limited partnership must be general partners. Partners in an LLP are not responsible for their own actions. Limited liability limited partnerships must have at least one general partner.

18. Practice Quiz Question #2 Solution Which of the following statements is true? The partners in a general partnership have limited liability. At least two of the partners in a limited partnership must be general partners. Partners in an LLP are not responsible for their own actions. Limited liability limited partnerships must have at least one general partner.

19. Learning Objective 3 Make calculations and journal entries for the formation of partnerships.

20. Partners’ Accounts • Each partner can have • a capital account. • a drawing account (a contra capital account—closed out at year-end). • a loan account (loans usually earn interest—a partnership expense). • Partnerships do NOT use aretained earnings account. DR CR

21. Keep it FAIR! Current Fair Market Values should be used to record noncash assets contributed to a partnership. liabilities assumed by a partnership. Recording Capital Contributions ABC Partnership

22. Partnership Formation Example Brian and Spencer wish to form the B&S partnership. Brian contributes land with a book value of $65,000 and a current value of $150,000 and a building with a book value of $142,000 and a current value of $175,000. Spencer will contribute cash. If the partners plan to share profits and losses equally after the formation of the partnership and assuming they have agreed to equal capital contributions, how much cash will Spencer have to contribute to form the partnership? $150,000 + $175,000 = $325,000

23. Comprehensive Partnership CreationGroup Problem The partnerships of Brad & Mike (B&M) and Austin and Justin (A&J) began business on 1/1/X1; each partnership owns one retail appliance store. The two partnerships agree to combine as of 7/1/X8 to form a new partnership, BAM-J Discount Stores. REQUIRED: Given the information on the next two slides, Prepare the journal entries to record the initial capital contribution after considering the effect of this information. Use separate entries for each of the combining partnerships. Prepare a schedule computing the cash contributed or withdrawn by each partner to bring the initial capital balances into the profit and loss sharing ratio.

24. Comprehensive Partnership CreationGroup Problem Profit and loss ratios. The profit and loss sharing ratios for the former partnerships were 40% to Brad and 60% to Mike, and 30% to Austin and 70% to Justin. The profit and loss sharing ratio for the new partnership is Brad, 20%; Mike, 30%; Austin, 15%; and Justin, 35%. Capital investments. The opening capital investments for the new partnership are to be in the same ratio as the profit and loss sharing ratios for the new partnership. If necessary, certain partners may have to contribute additional cash, and others may have to withdraw cash to bring the capital investments into the proper ratio. Accounts receivable. The partners agreed to set the new partnership’s allowance for bad debts at 3% of the accounts receivable contributed by B&M and 12% of the accounts receivable contributed by A&J. Inventory. The new partnership’s opening inventory is to be valued by the FIFO method. B&M used the FIFO method to value inventory (which approximates its current value), and A&J used the LIFO method. The LIFO inventory represents 85% of its FIFO value. Property and equipment. The partners agree that the building’s current value is approximately 70% of the building’s historical cost, as recorded on each partnership’s books. Unpaid liability. After each partnership’s books were closed on 6/30/X8, an unrecorded merchandise purchase of $1,500 by A&J was discovered. The merchandise had been sold by 6/30/X8. The 6/30/X8 postclosing trial balances of the partnerships follow:

25. Comprehensive Partnership CreationGroup Problem

26. Comprehensive Group Problem Solution PART 1 Summary of changes to carrying values: Allocate to:

27. Comprehensive Group Problem Solution Brad & Mike Journal Entry: Cash 25,000 Accounts Receivable 100,000 Allowance for doubtful accounts 3,000 Inventory 75,000 Building & Equipment 73,500 Accounts Payable 40,000 Notes Payable 100,000 Brad, Capital 91,600 Mike, Capital 138,900

28. Comprehensive Group Problem Solution Austin & Justin Journal Entry: Cash 22,000 Accounts Receivable 150,000 Allowance for doubtful accounts 18,000 Inventory 140,000 Building & Equipment 112,000 Accounts Payable 61,500 Notes Payable 120,000 Austin, Capital 71,150 Justin, Capital 153,350

29. Comprehensive Group Problem Solution PART 2

30. Learning Objective 4 Make calculations and journal entries for the operation of partnerships.

31. Accounting for Operations of a Partnership • Partners’ accounts • Capital accounts • Used to record the initial investment of a partner, any subsequent capital contributions, profit or loss distributions, and any withdrawals of capital by the partner • Deficiencies are usually eliminated by additional capital contributions Capital Investment Contributions % Loss % Profit

32. Accounting for Operations of a Partnership • Partners’ accounts • Drawing accounts • Used to record periodic withdrawals and is then closed to the partner’s capital account at the end of the period • Noncash drawings are valued at their market values at the date of the withdrawal • Loan accounts • A loan from a partner is shown as a payable on the partnership’s books • Unless all partners agree otherwise, the partnership is obligated to pay interest on the loan

33. Practice Quiz Question #3 Which of the following would result in a reduction to a partner’s capital account? a. The initial investment. b. The allocation of a profit. c. Additional capital contributions. d. A withdrawal. e. A loan to a partner.

34. Practice Quiz Question #3 Solution Which of the following would result in a reduction to a partner’s capital account? a. The initial investment. b. The allocation of a profit. c. Additional capital contributions. d. A withdrawal. e. A loan to a partner.

35. Learning Objective 5 Make calculations and journal entries for the allocation of partnership profit or loss.

36. Income Allocation Example Assume that in its first year of operation, B&S partnership earns $162,000 of income. What journal entry would B&S make to allocate the profits between the two partners? Profit & Loss Summary 162,000 Capital, Brian 81,000 Capital, Spencer 81,000

37. Partners can share profits and losses in any way they choose. Possible ways include ratios. salary allowances and ratios. imputed interest on capital, salary allowances, and ratios. capital balances only. performance methods. Sharing Profits and Losses

38. Group Exercise 1: Allocating Profit and Loss, No Restrictions The partnership of Alex and James has the following provisions: • Alex and James receive salary allowances of $37,000 and $18,000, respectively. • Interest is imputed at 10% on the average capital investment. • Any remaining profit or loss is shared between Alex and James in a 3:2 ratio, respectively. • Average Capital investments: Alex, $ 50,000; James, 130,000 REQUIRED 1. Prepare a schedule showing how the profit would be divided, assuming the partnership profit or loss is: a. $ 102,000 b. $ 57,000 c. $(34,000) 2. What journal entry should be made to allocate the profit or loss for each of the three cases listed above?

39. Group Exercise 1: Solution for part a Income Summary 102,000 Capital, Alex 59,400 Capital, James 42,600

40. Group Exercise 1: Solution for part b Income Summary 57,000 Capital, Alex 32,400 Capital, James 24,600

41. Group Exercise 1: Solution for part c Capital, Alex 22,200 Capital, James 11,800 Income Summary 34,000

42. Methods to Share Profits and Losses: “To the Extent Possible” Limitations • When a “limit” provision exists: • The next lower level method of sharing can be reached if and only if there is still unallocated profit remaining after dealing with the current level.

43. Group Exercise 2: Allocating Profit and Loss—“Limit” Assume the same information provided in Group Exercise 1, except that the partnership agreement stipulates the following order of priority: • Salary allowances (only to the extent available) • Imputed interest on average capital investments (only to the extent available). • Any remaining profit in a 3:2 ratio. (No mention is made regarding losses.) REQUIRED: The requirements are the same as for Group Exercise 1 (i.e., calculate the allocations and prepare journal entries). a. $ 102,000 b. $ 57,000 c. $ (34,000)

44. Group Exercise 2: Solution for part a Income Summary 102,000 Capital, Alex 59,400 Capital, James 42,600

45. Group Exercise 2: Solution for part b * $2,000 x (5,000 ÷ $18,000) = 556 $2,000 x ($13,000 ÷ $18,000) = 1,444 Income Summary 57,000 Capital, Alex 37,556 Capital, James 19,444

46. Group Exercise 2: Solution for part c In this case, the partnership agreement is vague. An argument can be made for allocating the loss equally pursuant the UPA 1997 because the partnership agreement is silent with respect to losses. Alternatively, we could presume that losses were intended to be shared in the residual profit-sharing ratio. In these cases, the accountant should seek clarification from each partner.

47. Practice Quiz Question #4 Matt and Chad created a partnership (M&C) on 12/31/X8 (sharing profits 50/50). Matt contributed equipment from his sole proprietorship having a carrying valueof $4,000 and a fair valueof $8,000. In 20X9, M&C had profits of $96,000 and borrowed $20,000 from a bank. In 2009, Matt withdrew $35,000 cash. Matt’s Y/E capital balance is a. $11,000. b. $17,000. c. $21,000. d. $56,000.

48. Practice Quiz Question #4 Solution Matt and Chad created a partnership (M&C) on 12/31/X8 (sharing profits 50/50). Matt contributed equipment from his sole proprietorship having a carrying valueof $4,000 and a fair valueof $8,000. In 20X9, M&C had profits of $96,000 and borrowed $20,000 from a bank. In 2009, Matt withdrew $35,000 cash. Matt’s Y/E capital balance is a. $11,000. b. $17,000. c. $21,000 ($8,000 + $96,000/2 - $35,000) d. $56,000.

49. Learning Objective 6 Make calculations and journal entries to account for changes in partnership ownership.

50. Interest $ Partner’s Admission: Purchase of An Existing Interest • The purchase of an interest from one or more of a partnership’s existing partners is a: • personal transaction between the incoming partner and the selling partner(s). • The only entry required on the partnership’s books is to transfer an amount: • from the selling partner’s Capital account. • to the new partner’s Capital account. C A B AB Partnership