Learning Objectives

Learning Objectives • At the end of the chapter, students would be able to: • Explain what a partnership business is • Differentiate between partnership and joint venture • Differentiate between different forms of partnership • Illustrate the main features of a partnership deed Financial Accounting

Learning Objectives • Explain the procedure to adopt in sharing profits/losses in a partnership business in the absence of a partnership deed. • Record transactions of, and draw up the ledger accounts and financial statements for a partnership business. Financial Accounting

Partnership Defined • A partnership business is where two or more individuals jointly set up a business (usually a long-term commitment) with a view to earn profit. • Partnership is defined by the partnership Act 1890 as ‘the relation which subsists between carrying on business in common with a view of profit’. Financial Accounting

A Joint Venture Business • A business agreement under which two businesses join together for a set of activities and agree to share the profit arising from these activities/ventures. • Thus, the cooperation in a joint venture is usually not for a long-term commitment. It may be for a one-off project/venture. Financial Accounting

Composition of Partnership • A partnership agreement may be oral or written • Individuals who form a partnership are called partners. • In most countries, only individuals above the age of 18 years can become (legal) partners. Financial Accounting

Composition of Partnership • In Malaysia, the number of partners is unlimited for certain professional firms (e.g. accounting and Law firms), but is limited to 10 in a banking business and 20 in other businesses. • It is common for partnership business names to end with ‘& Co. Example, Issah & Co. Financial Accounting

Accounting for Partnership • For accounting purposes a partnership is a separate legal entity. • Follows same GAAP procedures as accounting for corporations or sole proprietorships. • Primary difference is in the equity section and the treatment of partner’s capital accounts Financial Accounting

Contents of the Deed of Partnership The 'deed' will often contain some or all of the following clauses: • The capital to be contributed by each partner • The rate of interest to be allowed on partners capitals • The rate of interest to be charged on partners drawings • Any salaries payable to partners • The ratio in which the remaining profit / loss is to be shared Financial Accounting

In the absence of agreed partnership deed Should the partners fail to agree on the points stated in the deed (above) the Partnership Act 1890 states that the following will apply on a piecemeal basis: • Partners will receive interest at 5% on excess capital (i.e. over and above that which they have agreed to contribute) • No interest on drawings • No salaries • Profits / losses shared equally Financial Accounting

Different Forms of Partnership: Limited partnership • A limited partnership is a special form of partnership in which there are two classes of partners - general and limited • A limited partnership must have one or more general partner(s) and at least one limited partner. • There must be at least two individuals involved for the partnership to exist. The limited partner(s) use the business as an investment. They put money into the business and have a limited amount of liability. They can be liable for only the amount they invested, or an amount agreed upon in the partnership agreement. Financial Accounting

Partnership Formations GAAP Accounting • Assets contributed/debts assumed should be specified by partnership agreement • Assets can be cash/noncash and are recorded at FMV Financial Accounting

Partnership Formations- GAAP Accounting • Liabilities recorded at FMV • Capital accounts recorded as FMV of assets contributed less liabilities assumed by the partnership • If differences in asset values and agreed upon capital interests exist, bonus method or goodwill method is used to allocate differences Financial Accounting

Partnership Formations- Tax • General rule – non-recognition of g/l on creation of partnership • Tax law dictates the basis of assets for tax purposes with general rule that carryover basis is used. • Tacked holding periods generally exist for capital and Sec. 1231 assets held more than one year. Financial Accounting

Partnership Formations- Tax • Bonus/Goodwill method not used for tax. Any additional basis, etc will be reconciled upon the partners departure from partnership or liquidation of interest. • Tax capital accounts equal tax value of assets contributed less PV of liabilities assumed by the partnership. • Liabilities are valued at PV as of date of contribution. Financial Accounting

Allocation of Net Income/LossGAAP Accounting • Partnership agreement specifies profit and loss sharing arrangement • Common arrangements for p/l allocations: fixed ratio, ratio of capital balances at a point in time, initial capital contributions, time/talent etc. • Profits allocation and loss allocations may be different Financial Accounting

Allocation of Net Income/LossGAAP Accounting • Profits and loss arrangement may provide for salaries and bonuses to partners which are deducted from net income before salary and bonus allocations. • Partner draws are considered reductions of capital and are not treated as salary. Permission or draw procedure should be enumerated in the partnership agreement Financial Accounting

Allocation of Net Income/LossTax Law • Partnership agreement is very flexible, can be changed anytime before return is filed and should specify allocation rationale. • All allocations must meet the substantial economic effect requirements (to be discussed in Problem Area 7) • Profit/Loss sharing arrangements may be similar to GAAP if SEE rules are met. Financial Accounting

Allocation of Net Income/Loss Tax Law • Salaries/Bonus are either guaranteed payments or a special allocations of p/l depending on facts/circumstances. Sec 707 provides guidance. • Draws not considered income, but if reduce basis to negative amounts will trigger gain and possible at risk recapture. Financial Accounting

Changes in Partnership Ownership – GAAP ACCT • Change in ownership requires the partnership to be valued at the FMV of the date of change: • Important for former partners to ensure that they receive adequate payout for their interests • Important to determine purchase price for new partners etc. Financial Accounting

Changes in Partnership Ownership – GAAP ACCT • Revaluation must consider potential intangible assets such as goodwill. Bonus method (shift in book capital accounts for a difference in amounts contributed or goodwill method used Financial Accounting

Changes in Partnership Ownership – GAAP ACCT • Admission of new partner: • Purchase from another partner outside: Shift in capital accounts only. No change for valuation. • Purchase from partnership: Revalue partnership, adjust capital accounts of all partners for change in value of assets. Financial Accounting

Change in Partnership OwnershipTax Accounting • Partnership needs to determine fair value for purposes of determining payout and new partner purchase price. Admission of new partners: • If purchase outside partnership, no changes to tax balance sheet. Inside basis and outside basis will differ. New partner steps into the shoes of the old partner. If partnership has a Sec. 754 election in place, the tax basis of assets is written up to reflect the difference in outside and inside basis. Financial Accounting

Change in Partnership Ownership: Tax Accounting • If purchase from partnership, new partner pays FMV and with Section 754 election, partnership writes up assets to fair value but only for the portion attributed to the new partner not for all partners. Financial Accounting

Change in Partnership OwnershipWithdrawal/Retirement of Partner-GAAP • Determine FMV of assets and liabilities on the books. • If partnership agreement calls for it, a valuation of intangible should also be made. • If a payment is made above and beyond the net equity in recorded assets, bonus or goodwill method can be used to allocate the difference. • If payment is less than book value, the bonus method is used to reallocate the capital to remaining partners. Financial Accounting

Change in Partnership OwnershipWithdrawal/Retirement - Tax • If payment is less than book value because assets are overvalued, the firm should write down the assets to reflect this change. • Must recalculate FMV of partnership. • Payout the FMV of capital account Financial Accounting

Change in Partnership Ownership Withdrawal/ Retirement - Tax • Generally, no gain or loss is recognized on liquidation of partnership interest unless only cash or hot assets are distributed Financial Accounting

Liquidation: GAAP • Set partnership to FMV • Pay out creditors other than partners • Payout partners other than for capital and profits • Payout partners in respect of capital Financial Accounting

Liquidation: Tax • Payout creditors • Restore negative capital accounts • Liquidate partnership based on remaining capital accounts. • Payout partners in respect of profits • Restore any negative capital accounts Financial Accounting

Financial Statements of Partnership Business • Trading, Profit and Loss Account: This is similar to that of a sole proprietor. However, a partnership has an extra section shown under the profit & loss account. This section is known as ‘the profit & loss appropriation account. This section is used to make adjustments in respect of the following before the distribution of profit/loss: • Interest on partner’s drawings • Interest on partners capital (if any) • Partner’s salary (if any) Financial Accounting

Final Accounts: Profit & Loss Appropriate Accounts: Sample Steps: Compute net profit (as usual) XXX Add: Interest charges on partner’s drawings XXX Less: Interest paid on partner’s capital (XXX) Profit/loss available for distribution XXXX Share of profit (as pre-determined) Partner A XX Partner B XXXXXX Financial Accounting

Partner’s Capital Accounts • When a partner brings in capital (cash or other assets) into the business, that amount will be credited to his capital account. This amount (capital) will remain in the books at the original figure unless and until there are further injections (or withdrawals) of capital: • Example: Capital Account A Cash XXX B Lorry XXX XXX Financial Accounting

Partner’s Current Account • In order to preserve the original capital intact, a current account is prepared so as to deal with the following: • Partner’s drawings • Partner’s salary • Interest on capital • Interest on drawings and • Share of profit Financial Accounting

Partner’s Current Account.. • The current account (balance) fluctuates often unless the capital account • The current account balance may be Debit or Credit. When the amount of drawings exceeds the balance on a partner’s current account, the account will show a debit balance. If vice versa, the current account will show a credit balance. Financial Accounting

Accounting Entries for partnership Accounting Financial Accounting

Accounting Entries for partnership Accounting… Financial Accounting

Balance Sheet: some differences for a partnership • Capital account: the balance (b/d) is taking from the individual partner’s capital account. Capital account will most have a credit balance • Current account: The balance will be extracted from the individual partner’s current account. This balance may be a debit or credit balance. Financial Accounting

Balance Sheet: some differences for a partnership • Credit balance in current account: The balance will appear under the finance by (equity) section of the balance sheet. • Debit balance in the current account: The balance will appear as a minus in the equity section of the balance sheet. That is, it will be in negative (bracket). Financial Accounting

End of lecture 3 Thank U

Learning Objectives