Chapter 14: Partnerships - Formation and Operation

I.

Defined: A partnership is an association of two or more people or organizations formed to engage in some economic activity.

II.

Advantages: A. Partners abilities:

B. Ease of formation:

C. No partnership income taxes:

III.

Disadvantages: A. Unlimited legal liability:

B. Obtaining resources:

IV.

Owners Investments: Unlike corporation owners investments that are recorded in stockholders equity accounts, owners investments in partnerships are recorded in capital accounts. Assume that Lowell and Nashua form a partnership to provide internet art services. Lowell is an internet expert and Nashua has a significant amount of cash available from his previous business experience. To start the partnership, Lowell invests $10,000 and Nashua invests $40,000. The effects of their investments could be as follows.

Date

Accounts

Debits

Credits

Date Cash Lowell, Capital Nashua, Capital

Accounts

Debits 50,000

Credits 10,000 40,000

If the partners agreed to give equal credit to each partner, the effects would be as follows. Date Accounts Debits Credits

Date Cash Lowell, Capital Nashua, Capital

Accounts

Debits 50,000

Credits 25,000 25,000

Partners may agree to treat each other in any way they desire, as long as the arrangement is legal. If partners invest resources other than cash, such resources are usually recorded at their fair market value. The accounting terminology for partnerships differs from that of corporations.

V.

Withdrawals: Partners receive assets from a partnership by withdrawing them. Asset withdrawals by partners are recorded in partner withdrawal accounts.

If Lowell withdrew $500 and Nashua withdrew $400 from their partnership, the effects would be as follows.

Date Lowell, Drawing Nashua, Drawing Cash

Accounts

Debits 500 400

Credits 900

Each partners drawing account is a contra owners equity account (similar to the dividends account in a corporation). At the end of each accounting period, each partners drawing account is closed to the partners capital account.

If Lowells drawing account were closed to his capital account, the effects would be as follows. Date Accounts Debits Credits

Date Lowell, Capital Lowell, Drawing

Accounts

Debits 500

Credits 500

VI.

Income Allocation: Similar to corporations, at the end of each accounting period, partnership revenues and expenses are closed to income summary. Unlike corporations, however, in which income summary is closed to , partnership income summary is closed . This process of income allocation depends upon

Assume that the partnership agreement of Lowell and Nashua specifies that (1) each partner is to receive interest of 1% per month on his capital balance at the beginning of the month, (2) Lowell is to receive a monthly salary of $6,000 and Nashua is to receive $4,000, and (3) any remaining income is to be split equally between the partners. Assume that on April 1, 2007, Lowells

6 capital balance was $12,000 and Nashuas was $45,000. Assume also that the partnerships income for April was $18,000. Based on this data, the partnerships income would be distributed as shown below. Item Lowell Nashua Totals

Totals

Item Interest $12,000 x .01 $45,000 x .01 Salary Remaining income: $18,000 - $10,570 Totals

Lowell $120 $0 $6,000 $3,715 $9,835

Nashua $0 $450 $4,000 $3,715 $8,165

Totals $120 $450 $10,000 $7,430 $18,000

The above income allocation affects the partnership as follows. Date Accounts Debits Credits

Date Income Summary Lowell, Capital

Accounts

Debits 18,000

Credits 9,835

7 Nashua, Capital 8,165

Assume that instead of $18,000, the partnerships income for April was $9,000. Based on this data, the partnerships income would be distributed as shown below. Item Interest $12,000 x .01 $45,000 x .01 Salary Totals Lowell $120 $0 $6,000 Nashua $0 $450 $4,000 Totals $120 $450 $10,000

Item Interest $12,000 x .01 $45,000 x .01 Salary Remaining income: $9,000 - $10,570 Totals

Lowell $120 $0 $6,000 ($785) $5,335

Nashua $0 $450 $4,000 ($785) $3,665

Totals $120 $450 $10,000 ($1,570) $9,000

The above income allocation affects the partnership as follows. Date Accounts Debits Credits

Date Income Summary Lowell, Capital Nashua, Capital

Accounts

Debits 9,000

Credits 5,335 3,665

Assume that instead of $18,000, the partnerships income for April was a $1,000 loss. Based on this data, the partnerships income would be distributed as shown below. Item Interest $12,000 x .01 $45,000 x .01 Salary Totals Lowell $120 $0 $6,000 Nashua $0 $450 $4,000 Totals $120 $450 $10,000

9 Item Interest $12,000 x .01 $45,000 x .01 Salary Remaining income: - $1,000 - $10,570 Totals Lowell $120 $0 $6,000 ($5,785) $335 Nashua $0 $450 $4,000 ($5,785) ($1,335) Totals $120 $450 $10,000 ($11,570) ($1,000)

The above income allocation affects the partnership as follows. Date Accounts Debits Credits

Date

Accounts Nashua, Capital Income Summary Lowell, Capital

Debits 1,335

Credits 1,000 335

VII. Dissolution: Technically, a partnership is dissolved whenever there is a change in partners. A. Admission of a new partner: A new partner can be admitted to a partnership in two ways: (1) the purchase of an existing partners interest directly from the partner

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(2) the investing of resources directly in the partnership

1. Purchase of existing partners interest: When a new partner purchases an interest in a partnership by buying it directly from a current partner, the current partners capital interest is eliminated from the partnerships accounting records and the new partners interest is recorded.

For example, assume that Nashua sells his $65,000 capital interest to Orono for $78,000. In this case, Nashua receives $78,000 cash and Orono receives a $65,000 capital interest in the partnership. This method is called the book value method and the effects on the partnership would be as follows. Date Accounts Debits Credits

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Date Nashua, Capital Orono, Capital

Accounts

Debits 65,000

Credits 65,000

2. New partner investing resources directly in the partnership: When a new partner purchases an interest in a partnership by making payment directly to the partnership, the new partners capital interest is recorded. In its simplest terms, the new partners capital interest is recorded at that dollar amount equal to the new partners percentage interest in the partnership. For example, assume that Orono pays $30,000 to the Lowell and Nashua partnership for a 15% interest in the firm. Assume that immediately prior to the admission of Orono, the partners capital interests were as follows. Partner Lowell Nashua Totals Partners Capital $35,000 $65,000 $100,000 % 35% 65% 100%

12 Oronos $30,000 payment increases the partnerships net assets to $130,000. Oronos 15% capital interest would be $19,500 ($130,000 x .15). Since Orono paid $30,000 for a $19,500 interest in the partnership, the $10,500 excess payment ($30,000 - $19,500) would be allocated to the other partners according to their income sharing percentages. In this case, the capital balances of Lowell and Nashua would each increase by $5,250 ($10,500 / 2), since they share income equally. The effects on the partnership would be as follows. Date Accounts Debits Credits

Date Cash Lowell, Capital Nashua, Capital Orono, Capital

Accounts

Debits 30,000

Credits 5,250 5,250 19,500

After the admission of Orono, the partners capital interests would be as follows. Partner Lowell Nashua Orono Totals Partners Capital $40,250 $70,250 $19,500 $130,000 % 31% 54% 15% 100%

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B. Withdrawal of a partner: When a partner withdraws from a partnership, the partnership is dissolved according to the partnership agreement. If other partners remain in the partnership, a new partnership is formed.

Assume that Lowell decides to withdraw from the partnership. Immediately prior to his withdrawal, the partners capital interests were as follows. Partner Lowell Nashua Orono Totals Partners Capital $60,000 $100,000 $50,000 $210,000 Income Sharing % 40% 40% 20% 100%

If the partnership agreement requires an appraisal of the partnerships value before a partner withdraws and such an appraisal indicates that the partnerships value is $300,000, Lowell would receive $96,000 when he withdraws. The $96,000 was calculated as follows. Item Amount

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Item Lowell capital balance Lowell share of excess partnership value: ($300,000 - $210,000) x .40 Total

Amount $60,000 $36,000 $96,000

Lowells withdrawal would affect the partnership as follows. Date Accounts Debits Credits

Date Lowell, Capital Nashua, Capital Orono, Capital Cash

Accounts

Debits 60,000 24,000 12,000

Credits

96,000