Chapter 2 accounting for partnerships

Ledger Accounts for Partners contd.At the end of each accounting period, the income summary ledger account is transferred to the capital accounts in accordance with income sharing plan

All examples are from textbook by Larsen

Chapter 2

Accounting for Partnerships: Organization and Operation

Objectives of the Chapter

 To learn the accounting and reporting

for limited liability partnerships (LLPs)

including:

a the organization,

b the income-sharing plans,

c the financial statements, and

d the changes in ownership.

 To learn the accounting for limited

partnerships

 The Uniform Partnership Act defines a partnership as: "an association of two

or more persons to carry on, as

co-owners, a business for profit"

 Partnerships generally are associated with the practice of law, medicine,

public accounting and other

Partnerships (contd.)

 General partnership: in which all

partners have unlimited personal liability for debts of the partnership

 Limited liability partnerships (LLPs):

individual partners of LLPs are

personally responsible for their own

actions and for the actions of

employees under their supervision

Partnerships (contd.)

 The LLPs as a whole, like a general

partnership, is responsible for the

actions of all partners and employees

 Since the LLPs are the prevalent form

of partnerships and the issues of

organization, income-sharing plans and changes in ownership of LLPs are

Organization of a Limited Liability Partnership (LLP)

 Basic Characteristics of the LLP:

Major Differences between an LLP and a Corporation

Characteristics of a corporation:

1 Separated legal entity from its owners:

it can buy, sell and own properties.

2 Limited liability for stockholders.

3 Continuous existence.

4 Ease of transfer of ownership.

Ease of capital generation.

Major Differences between an LLP and a Corporation (contd.)

6 Centralized authority and responsibility

to the President, not to numerous

owners

7 Professional management

8 Corporation taxes (double taxation)

9 Separation of ownership and

management: principal & agent conflicts

10 Government regulations

Taxation of LLP

 An LLP pays no income tax

 LLP is only required to file an annual

information return showing its revenue

and expenses, the amount of its net

income and the division of the net income among the partners

Taxation of LLP

 The partners of LLP report their shares of

the ordinary net income from the

partnership and dividends and charitable contributions in their individual income

tax returns, regardless of whether they

received more of less than this amount of cash from the LLP

Is the LLP a Separate Entity ?

 Legal status: a partnership is an

"association of persons" and is not a

separate entity while a corporation is a separate entity from its owners.

 Economic substance: in terms of

managerial policy and business

objectives, LLPs are as much business

Is the LLP a Separate Entity ?

(contd).

 LLPs typically are guided by

long-range plans not likely to be affected

by the admission or departure of a

single partner.

 The accounting policies of LLPs

should reflect the fact that the

partnership is an accounting entity

apart from its owners

The Partnership Contract

 A good business practice requires

the partnership contract in writing.

 The followings are a few important

points to be covered in a written

contract for a LLP:

The Partnership Contract (contd.)

1. The formation date and the planned

duration of the partnership; the names

of the partners, and the name and

business activities of the partnership

2. The assets to be invested by each

partner, the procedure for valuing

noncash investments, and the

penalties for a partner's failure to

invest and maintain the agreed

amount of capital

The Partnership Contract (contd.)

3. The authority, the rights and the duties

of each partner

4. The accounting period to be used, the

nature of accounting records, financial statements and audits by independent public accountants

5. The net income (loss) sharing plans

The Partnership Contract (contd.)

6. The drawings allowed to each partner

7. Insurance on the lives of partners

8. Provision for arbitration of disputes.

9. Provision for liquidation of the

partnership at the end of the term

specified in the contract or at the death

or retirement of a partner

Ledger Accounts for Partners

 The following three types of accounts

are used in LLPs for each partner:

1. Capital accounts

2. Drawing accounts

3. Accounts for loans to and from

partners

Ledger Accounts for Partners (contd.)

 The original investment from partner is

recorded as: Assets (based on current fair value) $$$ Liabilities $

$$ Capital-Partner A $$$

 Drawings from Partners are recorded as: Drawing –Partner A $$$

Cash $$$

Ledger Accounts for Partners (contd.)

At the end of each accounting period,

the income summary ledger account is

transferred to the capital accounts in

accordance with income sharing plan

specified in the contract

Also, the debit balances in the drawing

accounts are closed to the partner's

capital account

Ledger Accounts for Partners (contd.)

Loans Receivable from Partners: this

account is debited when a partner

receives cash from the LLP with the

intention to repay this amount

Loans Payable to Partners: this

account is credited when a partner

makes a cash payment to the LLP that

is considered a loan rather than an

investment

Ledger Accounts for Partners (contd.)

If a substantial unsecured loan has

been made to a partner and repayment appears doubtful, it is appropriate to

offset the receivable against the

partner's capital account

Valuation of Investments by Partners

Gains or losses from disposal of

noncash assets invested by the

partners is measured as:

The disposal price – the current fair value of the assets when invested

adjusted for any depreciation or amortization to the date

of disposal

These gains (losses) are divided based

on the income sharing plan of the LLP

Income-Sharing Plans for LLP

Partners can agree on any type of income sharing plan regardless of the amount of

their respective capital investment

The Uniform Partnership Act states that if partners fail to specify a plan for sharing

net income/loss, it is assumed that they

intend to share equally

Income-Sharing Plans for LLP

(contd.)

 The following are a few possible plans of

income-sharing:

1. Equally

2. In the ratio of partners' capital account

balance on a specific date or in the ratio

of average capital account balance in the year

3. Allowing interest on partner's capital

account balances and dividing the

remaining net income/loss in a specified ratio

Income-Sharing Plans for LLP

(contd.)

4. Allowing salaries to partners and dividing

the remaining net income/loss in a

specified ratio

5. Bonus to managing partner based on

income

6. Allowing salaries to partners, allowing

interest on capital account balances, and dividing the remaining net income/loss in

a specified ratio

Income-Sharing Plans for

LLP-Examples

Alb & Bay LLP had a net income of

$300,000 for the year ended 12/31/99, the first year of operation

The partnership contract provides that each partner may withdraw $5,000 cash on the

last day of each month Both partners did

so during 1999

All other withdrawals, investments and net income/loss are entered directly in the

capital account

Income-Sharing Plans for

LLP-Examples (contd.)

Alb invested $4,000,000 on 1/1/99 and an additional $100,000 on 4/1 Bay invested

$800,000 on 1/1/ and withdrew $50,000 on 7/1

These transactions and events are

summarized in the following ledger

accounts:

Income-Sharing Plans for

LLP-Examples (contd.)

Alb, Capital Bay, Capital

400,000…1/1 7/1 50,000 800,000 1/1 100,000…4/1

Income-Sharing Plans for

LLP-Examples (contd.)

 I f the entire net income is shared equally, the following entry is recorded:

Income Summary 300,000 Alb, Capital 150,000 Bay, Capital 150,000

At the end of 1999, the drawing accounts are to be

closed to Income Summary as follows:

Alb, Capital 60,000

Bay, Capital 60,000

Alb,Drawing 60,000

Income-Sharing Plans for

LLP-Examples (contd.)

The entire income/loss can be shared at

any specified ratio specified in the contract

LLP can apply one sharing ration to net

income but another ratio to net loss

LLP can apply one sharing ratio to net

income equal or less than a specific amount but another ratio to net income greater than that amount

Income-Sharing Plans for

LLP-Examples (contd.)

The entire income/loss of LLP can also be shared by the ratio of partners' capital

account balances such as:

by the original capital investments,

by the capital account balance at the,

beginning of each year,

by the balances at the end of each year

(before the distribution of net income/loss), and

Income-Sharing Plans for

LLP-Examples (contd.)

 The assumption of the sharing based on

the capital ratio is that the capital

investment is the sole determinant of the income of LLP

 Thus, another common practice in

income sharing of LLP is to divide only a portion of net income in the capital ratio and to divide the remainder equally or in some other specified ratio

Interest on Partner's Capital account

balances with Remaining Divided in Specified Ratio

 A method to carry out the above sharing

scheme is to allow interest on partners' capital balance at 15%, for example, and dividing the

remainder at a specified ratio.

 This method is the same as dividing only a

portion of net income in the ratio of partners'

capital balances.

 If this income sharing scheme is used, LLP

needs to specify the interest rate and the

Interest on Partner's Capital account

balances with Remaining Divided in Specified Ratio

Example: Assume that the partnership

contract allows interest on partners'

average capital account balances at 15%

with remainder to be divided equally

The net income of $300,000 for 1999 is

divided as follows:

Note: the average capital balances for Alb

and Bay are $475,000 and $775,000,

respectively

Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio

Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (condt.)

 The provision of allowing interest on

capital balance should be carried out

even in the case of net loss unless

otherwise indicated in the contract

 Example (with net loss): assume that

$10,000 net loss incurred for the year of

1999, the following table presents the

division of the net loss for the year of

1999:

Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (condt.)

Alb Bay Combined Interest on average capital

account balances:

Alb: $475,000X0.15 $71,250 $71,250 Bay: $775,000X0.15 $116,250 116,250

Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (condt.)

The journal entry to close the Income

Summary ledger account on December 31,

Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (condt.)

 The rational underlies the above

allocation:

assumes that capital is NOT the only

factor to cause the net loss;

therefore, the net loss should not be allocated solely on the capital ratio.

Salary Allowance with Remaining Net

Income Divided in Specific ratio

 One partner may contribute more services

to the LLP than the other.

 If the income-sharing is based solely on

the amount of services provided by each partner, the following problems arise:

 1) the success of a LLP is not determined

solely by the services provided by

partners

 2) in the case of net loss, the partner

renders more services will absorb a larger portion of the loss.

Salary Allowance with Remaining Net

Income Divided in Specific ratio (contd.)

 One solution to avoid these problems as

well as recognize the unequal services of partners is to provide salaries to partners based on their services to the LLP

 The remaining net income is to be shared

equally or in a specified ratio

 Example: assume the contract provides

for an annual salary of $100,000 to Alb

Salary Allowance with Remaining Net

Income Divided in Specific ratio (contd.)

Alb Bay Combined Salaries $100,000 $60,000 $160,000 Net income ($300,000-

$160,000) divided equally

70,000 70,000 140,000 Totals $170,000 $130,000 $300,000

The salaries are paid monthly during the year The net income of $140,000

($300,000-100,000-60,000) for 1999 is

divided as follows:

Salary Allowance with Remaining Net

Income Divided in Specific ratio (contd.)

 Monthly Journal Entries:

Salaries Expense 13,333

Capital –Alb 8,333

Capital-Bay 5,000

Alb, Drawing 8,333

Bay, Drawing 5,000 Cash 13,333

Income Summary 140,000

Alb, Capital 70,000

Bonus to Managing Partner Based

on Income

 A partnership contract may provide

bonus to the managing partners equal

to a specified % of income

 The contract should state whether the

% is based on the income prior to the bonus or after the bonus

 Example (% is based on the income

after the bonus):

Bonus to Managing Partner Based

on Income (contd.)

 Assume that the net income is

$300,000 and the contract provided for

a bonus of 25% of income after the bonus to Partner Alb The remainder of net income is to be divided equally The bonus to Alb is computed as follows:

 0.25 x ($300,000-B) = B =>

$75,000 = 1.25 x B => B = $60,000

 Note: The concept of a bonus is not

Salaries to Partners with Interest on Capital Accounts

 Many LLPs divide income or loss by

allowing salaries to partners and also interest on their capital account balances.

 Any resultant net income or loss is divided

equally or in some other ratio.

 Example: assume the following:

1 Annual salaries of $100,000 to Alb and

$60,000 to Bay, recognized as operating expense.

Salaries to Partners with Interest on Capital Accounts (contd.)

2. Interest on average capital account

balances, as computed on page 39 ($71,250 for Alb and $116,250 for Bay).

3. The remaining net income or loss

divided equally

4. Assuming income of $300,000 fir 1999

before annual salaries, the $140,000 net income is divided as follows:

Salaries to Partners with Interest on Capital Accounts –Example (contd.)

Alb Bay Combined Interest on average capital

account balances:

Alb: $475,000X0.15 $71,250 $71,250 Bay: $775,000X0.15 $116,250 116,250

Financial Statements of an LLP –

Income Statement

Partners’ salaries expense $160,000

Other operating expenses 900,000 1,060,000

Division of net income:

Financial Statements of an LLP –

Income Statement (contd.)

 Notes to the I/S:

1. Explanations of the division of net

income may be included in the

partnership's income statement or in

a note to the financial statements.

2. A partnership in not subject to

income taxes.