CHAPTER Partnership Accounting - Pearson

1 14 CHAPTERP artnership AccountingLEARNING OBJECTIVESWhen you have completed this CHAPTER , you a better understanding of Accounting the general characteristics of a Partnership and the importanceof each able to calculate the division of profits, prepare the proper journal entries,and prepare the financial statements for a able to calculate and prepare the journal entries for the sale of a partner-ship interest, the withdrawal of a partner, and the addition of a able to calculate and prepare the journal entries for a Partnership that isgoing out of form a balance sheet that shows assets on the left-hand side and liabilities andbalance sheetowner s equity on the right-hand sidedeficita deficiency in amount; , in this CHAPTER , a deficit balance in the capitalaccount is an abnormal, or a debit, balanceliquidationto settle the accounts and distribute the assets of a businessmutual agencythe legal ability of a partner to bind the Partnership to contracts within thescope of the partnershippartnershipa voluntary association of two or more legally competent persons who agree todo business as co-owners for profitprofit-loss ratiothe method chosen by partners for dividing the profits or losses; also called theincome and loss sharing ratiorealizationthe conversion of noncash assets to cashunlimited liabilityeach partner is personallyliable for the business debtsIntroductionThe three common types of business are the proprietorship, the corporation, and thepartnership.

2 It is important to note that corporations, though fewer in number thanproprietorships or partnerships, transact at least 10 times the business of all other busi-ness forms combined. There are advantages and disadvantages to each type of for a Partnership is similar to Accounting for a proprietorship exceptthere is more than one Partnership CharacteristicsGeneral partnerships and limited partnerships are recognized by Canadian law. In thischapter, we will concentrate on general partnerships, which are governed by provinciallaw and registration requirements, and which have certain characteristics. Following is adiscussion of AssociationA partnershipis a voluntary association of two or more legally competent persons (per-sons who are of age and sound mental capacity) to carry on as co-owners a business forprofit. Because a Partnership is based on agreement, no person can be a partner againsther or his will.

3 Doctors, accountants, and lawyers frequently form partnerships, and thisform of business organization is common in small service and retail AgreementTwo or more legally competent people may form a Partnership . It is best if their agree-ment is in writing, but it may be expressed verbally. The Partnership contract is preparedby a lawyer, though an acccountant may review it. The contract will stipulate, amongother things, how Partnership income and losses are to be divided among the Partnership is taxed like a proprietorship. In other words, the partners are taxed basedupon the Partnership s net income, not on their withdrawals from the LifeA Partnership is a business carried on by individuals and can not exist separate and apartfrom those individuals. Should something happen to take away the ability of a partnerto contract (death, bankruptcy or lack of legal capacity), the Partnership may be termi-nated.

4 Also, the life of a Partnership may be limited by terms in the Partnership contract ,or it may be terminated by any one of the partners at AgencyMutual agencyis the legal ability of each partner, acting as an agent of the business, toenter into and bind it to contracts within the scope of the Partnership . For example,Alyce, Ben, and Charlie are partners in an Accounting firm. Ben may bind the partner-ship by contracting to buy a computer for the business, even if the other two partnersknow nothing of the purchase. They are bound to the contract because a computer is anexpected and necessary piece of equipment for an Accounting firm. However, the firmwould not be bound if Ben should contract to buy land with the expectation that itsvalue would increase because this transaction is considered to be outside the purpose ofan Accounting may agree to limit the power of one or more of the partners to negotiate con-tracts for the business.

5 Outsiders are bound by this agreement only if they are aware of LiabilityMuch like in a proprietorship, partners have unlimited liability for their liabilitymeans that each partner is personally liable for the debts of thePartnership Accounting377business. When a Partnership business is unable to pay its debts, the creditors may sat-isfy their claims from the personal assets of any of the partners. If any one partner cannot pay her or his share of the debt, creditors may make their claims against any of theother and disadvantages of a PartnershipA Partnership has advantages over other forms of business. By combining the abilitiesand capital of two or more persons, business potential may be greatly expanded. Also, apartnership is much easier to form than a corporation because an agreement betweenparties is all that is required. However, there are several disadvantages limited life,unlimited liability, and mutual agency are among these and pose potential legal prob-lems that must be considered when forming any new Drawing AccountPartnership Accounting is the same as Accounting for a proprietorship except there areseparate capital and drawing accounts for each partner.

6 The fundamental accountingequation (Assets = Liabilities + Owner s Equity) remains unchanged except that totalowners equity is the sum of the partners capital accounts. Similar to a proprietorship,the partners (owners) do not receive salaries but withdraw assets from the business fortheir personal needs. Generally, the rules for withdrawals are decided beforehand by thepartnership agreement. For example, assume that Partner Arnold withdraws $5,000from a Partnership firm of which he is a member. The journal entry to show this with-drawal is as follows:At the end of the Accounting period, the drawing accounts of each partner are closedto their individual capital accounts. Following is the journal entry to close the drawingaccount of Partner Arnold to his capital 15 Arnold, Drawing500000 Cash500000To Record the Withdrawal of CashGENERAL 31 Arnold, Capital500000 Arnold, Drawing500000To Record the Closing of Arnold s DrawingAccount to CapitalAccounting for a Partnership requires calculations be made for the division of prof-its and losses and the preparation of journal entries for the addition or withdrawal of apartner.

7 In addition, special problems must be solved when a Partnership is going out ofbusiness. Each of these will be discussed in the following the Net IncomeRemember that partners are owners of the business, not employees, and as such, maydivide their net income as they choose. The Partnership contract , however, must statehow the net income or loss is to be divided. If there is no contract , the law states thatprofits and losses will be divided equally. The method chosen by the partners for divid-ing the profits or losses is called the profit-loss ratio. This CHAPTER will discuss a num-ber of methods that may be used. Profits and losses:1. may be divided equally2. may be distributed on a fractional basis3. may be distributed based on amounts invested4. may be distributed using a fixed ratio5. may be distributed using a salary allowance with any remaining profits dividedequally or using a ratioDividing Net Income EquallyPartners may divide profits equally.

8 For example, M. Saar, J. Loretto, and S. Abdullah arepartners. Saar invested $50,000 in cash and other assets, Loretto invested $30,000 cash,and Abdullah invested $40,000 cash in their Accounting firm. The following balancesheet was prepared on December 31 before adjusting and closing entries for the year hadbeen Accounting379 Saar, Loretto, and Abdullah, AccountantsBalance SheetDecember 31, 20 XXAssetsCash$8000000 Other Assets5000000 Total Assets$13000000 LiabilitiesAccounts Payable$1000000 Owners EquitySaar, Capital5000000 Loretto, Capital3000000 Abdullah, Capital400000012000000 Total Liabilities and Owners Equity$13000000 Revenues were $96,000 and expenses were $60,000, leaving $36,000 net income to bedistributed to the three partners capital accounts. Once the amount to be allocated is deter-mined, a closing entry crediting the capital accounts is required. If net income is to bedivided equally, the Income summary account is closed to the capital accounts as follows:Dividing Net Income Based on Amounts InvestedThe partners may agree to divide net income using a fraction determined by using theamounts of the original capital investment.

9 The following shows the steps involved inthis calculation:1. Determine the amounts originally $ 50,000 Loretto30,000 Abdullah40,000 Total$120,0002. Determine fractions. (The denominator is the total amount invested, $120,000,and each partner s individual investment becomes the numerator.)Profits to beTotalRatioDividedAllocatedSaar50,000=5 $36,000=$15,000120,00012 Loretto30,000=3 36,000=9,000120,00012 Abdullah40,000=4 36,000=12,000120,00012 Total to be allocated$36,000 The general journal entry to close the Income summary to the capital accounts is asfollows:380 CHAPTER fourteenGENERAL 31 Income Summary3600000 Saar, Capital1200000 Loretto, Capital1200000 Abdullah, Capital1200000To Close Income summary to CapitalDividing Net Income Using a Fixed RatioIn the Partnership agreement, the contract may specify a fixed ratio to be used to dividethe profits or losses. For example, Saar, Loretto, and Abdullah decide to use a ratio of3:2:1, respectively.

10 To use this ratio, convert the ratio into a fraction and multiply it bythe net income or loss of the period. The steps for using the ratio to divide the profit areas follows:1. Determine the fraction from the ratio. Add: 3 + 2 + 1 = 6. Thus, 6 becomes thedenominator of the fraction. The numerators are the numbers in the or 1/2 Loretto2/6 or 1/3 Abdullah1/62. Calculate the distribution to beTotalFractionDividedAllocatedSaar1/2 $36,000=$18,000 Loretto1/3 $36,000=12,000 Abdullah1/6 $36,000=6,000 Total$36,000 The general journal entry to close the Income summary to the capital accounts is asfollows: Partnership Accounting381 GENERAL 31 Income Summary3600000 Saar, Capital1500000 Loretto, Capital900000 Abdullah, Capital1200000To Record the Closing of the Income summary to CapitalGENERAL 31 Income Summary3600000 Saar, Capital1800000 Loretto, Capital1200000 Abdullah, Capital600000To Record the Closing of the Income summary to CapitalDividing Net Income by Paying Interest onInvestments and Salary AllowancesAnother common way to divide profits is to pay interest on the original capital invest-ments, give a salary allowance, and divide any remainder equally or according to a fixedratio.