Principles of financial accounting 12e by needles crosson chapter 12

is good business practice to have a written partnership agreement that clearly states: – Name, location, and purpose of the business – Names of the partners and their respective duties

Concepts Underlying Partnerships

 A partnership , as defined by the

Uniform Partnership Act, is an

association of two or more persons to

carry on as co-owners of a business for profit.

– Partnerships are treated as separate

entities, with their own accounting records

and financial statements.

– Legally, there is no economic separation

between a partnership and its owners

Characteristics of Partnerships

(slide 1 of 3)

association of individuals Therefore, a partner is legally responsible for his or her partners’ actions within the scope of the business.

is good business practice to have a written

partnership agreement that clearly states:

– Name, location, and purpose of the business

– Names of the partners and their respective duties

– Investments of each partner

– Method of distributing income and losses

– Procedures for the admission and withdrawal of partners, the withdrawal of assets, and the liquidation of the

business

Characteristics of Partnerships

(slide 2 of 3)

may be dissolved when:

– a new partner is admitted

– a partner withdraws, goes bankrupt, is incapacitated,

retires, or dies – the terms of the partnership agreement are met, such as when the project for which the partnership was formed is completed

partnership within the scope of the business

bind the partnership to a business agreement as long as he or she acts within the scope of the

company’s normal operations.

Characteristics of Partnerships

(slide 3 of 3)

unlimited liability for all the debts of the

partnership If the assets of the business are not enough to pay all the debts of the business,

creditors can seek payment from the personal

assets of each partner.

individuals invest property in a partnership, the property becomes an asset of the partnership

and is owned jointly by the partners.

has the right to share in the partnership’s income and the responsibility to share in its losses.

Advantages and Disadvantages of

Partnerships

 Advantages

– Can be easy to form,

change, and dissolve.

– Facilitates the pooling

of capital resources and individual talents.

– Has no corporate tax

burden.

– Gives the partners a

certain amount of freedom and

flexibility.

– The life of a partnership is limited – One partner can bind the partnership to a contract.

– Partners have unlimited personal liability.

– It is more difficult for

a partnership to raise capital than it is for a corporation.

Accounting for Partners’ Equity

 Accounting for a partnership is similar

to accounting for a sole proprietorship, but there are differences.

– Owner’s equity in a partnership is called

partners ’ equity – It is necessary to divide the income and

losses of the company between the partners.

– It is necessary to maintain separate Capital and Withdrawals accounts for each partner.

Distribution of Partnership Income and Losses

 A partnership’s income and losses can be

distributed according to whatever method the

partners specify in the partnership agreement.

– If the agreement does not specify this, the

partners share income and losses equally.

– Income in a partnership normally has three

components:

interest on partners’ capital)

partners may make to the partnership or for risks they may take

Stated Ratios

 One method of distributing income and

losses is to give each partner a stated ratio of the total income or loss

– If each partner is making an equal contribution to the firm, each can assume the same share of

income and losses.

– An equal contribution does not necessarily mean

an equal capital investment, because one partner may be devoting more time and another partner more capital.

– If the partners contribute unequally to the firm,

unequal stated ratios can be appropriate.

Capital Balance Ratios

 Income and losses may be distributed according to capital balances

 The ratio used may be based on each partner’s capital balance at the

beginning of the year or on the average capital balance of each partner during the year.

Salaries, Interest, and Stated Ratios

 To make up for unequal contributions to

a firm, a partnership agreement can

allow for partners’ salaries, interest on partners’ capital balances, or both in

the distribution of income

– Salaries and interest of this kind are not

deducted as expenses before the partnership income is determined.

Dissolution of a Partnership

 Dissolution of a partnership occurs whenever there

is a change in the original association of partners.

– When a partnership is dissolved, the partners lose their authority to continue the business as a

going concern.

– This does not mean that the business operation necessarily is ended or interrupted, but from a legal standpoint, the separate entity ceases to exist.

– The dissolution may take place through the

admission of a new partner, the withdrawal of a partner, or the death of a partner.

Admission of a New Partner

 The admission of a new partner dissolves

the old partnership because a new

association has been formed

– Dissolving the old partnership and creating a

new one requires the consent of all the original partners and the ratification of a new

Bonus to the Old Partners

 A new investor is sometimes willing to pay more than the actual dollar interest he or she receives in the partnership

 The excess of the payment over the

interest purchased is a bonus to the

Bonus to the New Partner

 A partnership might want a new partner for several reasons

– A partnership in financial trouble might need additional cash, or the partners might want

to expand the firm’s markets and need more capital.

– The partners might also know a person who would bring a unique talent to the firm.

– Under these conditions, part of the original partners’ capital may be transferred to the new partner’s Capital account as a bonus.

Withdrawal of a Partner

 Generally, a partner has the right to

withdraw from a partnership in accord

with legal requirements.

– The partnership agreement should describe

the procedures to be followed, including:

 Whether an audit will be performed

 How the assets will be reappraised

 How a bonus will be determined

 By what method the withdrawing partner will be paid

– A partner can withdraw from a partnership in one of several ways.

Withdrawal Not Equal to Capital Balance

 A partner’s withdrawal is not always equal to the that partner’s capital account.

– When a withdrawing partner removes assets that are less than his or her capital balance, the equity that the partner leaves in the business is divided among the remaining partners according to their stated ratios.

– When a withdrawing partner takes out assets that are greater than his or her capital balance, the excess is treated as a bonus to the withdrawing partner The remaining partners absorb the bonus

by reducing their capital accounts according to their stated ratios.

Death of a Partner

 When a partner dies, the partnership is

dissolved because the original association

has changed.

– Normally the books are closed, and financial

statements are prepared to determine the capital balance of each partner on the date of death.

– The remaining partners may purchase the

deceased’s equity, sell it to outsiders, or deliver certain business assets to the estate of the

deceased partner.

– If the firm intends to continue, a new partnership must be formed.

Liquidation of a Partnership

 The liquidation of a partnership is the

process of selling enough assets to pay the partnership’s liabilities and distributing any remaining assets among the partners.

– Liquidation is a form of dissolution.

– As the assets of the business are sold, any gain or losses should be distributed according to the

stated ratios.

– As cash becomes available, it must be applied first

to outside creditors, then to loans from partners, and finally to the partners’ capital balances.

Limited Partnerships

 A limited partnership (LP) is a special type of partnership that, like

corporations, confines the limited

partner’s potential loss to the amount of his or her investment in the business.

– Under this type of partnership, the unlimited liability disadvantage can be overcome.

– Usually, the limited partnership has a general partner who has unlimited liability but allows other partners to limit their potential loss

– They are often used by U.S companies that want to

make investments abroad.

Companies That Look Like Partnerships

 S corporations —corporations that U.S tax laws treat

as partnerships

– Unlike normal corporations, they do not pay federal income

taxes

– They have a limited number of stockholders, who report the

income or losses on their investments in the business on their personal tax returns.

 Limited liability company (LLC) —companies whose members are partners, but their liability is limited to

their investment in the business

 Special-purpose entities (SPEs) —firms with limited lives that a company creates to achieve a specific

objective, such as raising money by selling receivables