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Partnerships

ACC 13/1/1

What is a partnership?
Two or more individuals form a
partnership to run a business together to
hopefully achieve a prot.

Discussion: What partnerships are there in the local


area?
What types of businesses are o6en formed as
partnerships?

Why form a partnership rather than


remain as a sole proprietor?
Finances
When forming a new business, FINANCE is o6en the
most important point. In most cases, people that
start new businesses do so with their own personal
assets and/or a loan from the local bank.
If two or more people join to form a new business
then it is gets much easier to raise sucient funds
and it reduces the burden from one persons
personal assets.
n

Why form a partnership rather than


remain as a sole proprietor?
n

Sharing of Management, Skills & Knowledge


It is simply much easier to manage the day-to-day
acIviIes of a business with carefully chosen partners.
Partners give each other free Ime and provide dierent
valuable skills and perspecIves. Suppose that someone
has a good idea for a business but lacks the accountancy
and management skills to run the business, it would be
more benecial to take on a partner that would work
harder for the business to succeed than hiring an
outside accountant or consultant who doesnt have a
personal investment in the
partnership.

Why form a partnership rather than


remain as a sole proprietor?
n

People Take Partnerships More Seriously


Customers prefer a partnership business to a
business run by one sole person. The percepIon is
that partnerships are more reliable because there is
more than one person looking a6er the business
and ensuring its survival. It has been proven that
partnerships last longer than sole proprietorships. It
is believed that a business person performs beQer
and works in a more disciplined way, if he/she is
being watched by another partner.

Legalities of a Partnership
In New Zealand we have the Partnership Act 1908
which outlines the legaliIes of a partnership.
Legal deniIon of a partnership:

Partnership is the relaIon which subsists between


persons carrying on a business in common with a view
to prot.

Legalities of a Partnership
Therefore, for a partnership to exist:
there must be more than one person
the partners must be carrying on a business
together
The partners operate the business with the view
to make a prot

Legalities of a Partnership
Partnership Act 1908 - Liability of the partners:
Every partner in a rm is liable jointly with the other
partners for all debts and obligaIons of the rm
incurred while he is a partner; and a6er his death his
estate is also severally liable in a due course of
administraIon for such debts and obligaIons as far as
they remain unsaIsed, but subject to the prior
payment of his separate debts.

Legalities of a Partnership
Liability of the partners:
What does this mean?
The partners are all individual legal enJJes
themselves and they are all liable for all of the
partnerships debts. Just like a sole proprietor, the
personal assets of the partner can be used to pay the
partnerships debts.

Legalities of a Partnership
Partnership Act 1908 - Sharing of prot by partners:
The interests of partners in the partnership property,
and their rights and duIes in relaIon to the
partnership, shall be determined, subject to any
agreement (express or implied) between the partners,
by the following rules:
n All the partners are enItled to share equally in the
capital and prots of the business, and must
contribute equally towards the losses, whether of
capital or otherwise, sustained by the rm

Legalities of a Partnership
Sharing of prot by partners:
What does this mean?
Unless there is a Partnership Agreement that states
otherwise, the prots of the partnership must be
shared EQUALLY between the partners.

Partnership Agreement
Most partnerships will have a formal Partnership
Agreement drawn up when the business is formed.

The Partnership Act 1908 default provisions are not
likely to be in the partners interest so most partners
use a Partnership Agreement to formalise an
alternaIve.

Partnership Agreement
The most important areas to consider are:
n Prot sharing
n Control of business decisions
n AdmiQance and expulsion of partners
n ValuaIon of intangible assets (such as trade names
and customer goodwill)
n Liability for partnership debts
n TerminaIon

Why have a Partnership Agreement?


There are many situaIons where something could go
wrong. As an example, by default, all partners have
equal responsibility and liability for partnership debts.
Unless your Partnership Agreement sets out otherwise,
one of your partners could take on a contract that
turns bad and leaves you personally nancially
responsible for repayment.

Why have a Partnership Agreement?


To protect the ideas/intellectual property of the
partnership, the agreement might want to have a
clause that states that there is a certain amount of Ime
that must pass a6er a partner leaves the partnership
before they can set up in compeIIon to the
partnership, if at all.

Why have a Partnership Agreement?


How the prot is shared out is detailed in the
Partnership Agreement based on capital investment by
each partner; work done in the partnership; drawings
taken by the partner etc.

Partnership Agreement Profit


Sharing Clauses
Prot
Clause

Example of Clause

ExplanaJon of Clause

Salaries Partner A is to receive a


salary of $20,000 per
year, Partner B is to
receive a salary of
$30,000 per year

To recognise the physical


input (work) from partners
into the partnership

Interest Each partner is to receive


on
interest on capital at a
Capital rate of 8% on average
monthly capital balances

To reward partners for the


risk taken with invesIng
funds into the partnership
and to recognise the
dierent amounts of capital
contributed by the partners

Partnership Agreement Profit


Sharing Clauses
Prot
Clause

Example of Clause

ExplanaJon of Clause

Interest on Each partner is to be


To encourage prots to be
Current
charged/receive interest retained in the
on current accounts of
partnership
5% charged/given on
opening current balance
Interest on Each partner is to be
To discourage partners
Drawings charged 10% on drawings from excessive amounts
above $15,000
of drawings

Partnership Agreement Profit


Sharing Clauses
Prot
Clause

Example of Clause

ExplanaJon of Clause

Bonus

Partner A will receive


5% bonus on sales
above $200,000

An incenIve for a partner


to reach/exceed desired
performance targets

Share of Residual prots/losses


prot/loss are to be shared in the
raIo of 2:1 (Partner A:
Partner B)

The prot/loss sharing


raIo recognises the
dierent contribuIons (eg
capital, Ime, skills) made
by each partner.

Forming a Partnership
Once it has been decided that a partnership will
be formed and the Partnership Agreement has
been wriQen, the accounts of the partnership
can be opened starIng with the formaIon
entries.

Forming a Partnership
Partnership business may be formed by:
n each partner contribuIng cash
n each partner contribuIng cash and some
personal assets (for example a vehicle, computer,
building)
n one person who is currently a sole proprietor
running a business and another person contribuIng
cash and/or assets to become a partner in the
business

Forming a Partnership
Each partner contributes cash


Bank

Capital Partner A

Bank
Capital Partner B

Debit

Credit

50 000

50 000

100 000
100 000

Forming a Partnership
One partner contributes cash and the other partner
contributes cash and an asset

Debit

Bank

50 000

Capital Partner A

Bank
Vehicle
Capital Partner B

Credit

50 000
100 000
20 000
120 000

Forming a Partnership
One partner contributes an exisIng business and one
partner contributes cash.
The assets and liabiliIes of the business will be taken over
at their agreed values (as decided by the partners, maybe
their book values)
The sole proprietorship being contributed to the
partnership is a going concern and the value of the sole
proprietorship becomes the capital of the partner that is
contribuIng the business.
If the valuaIon of the sole proprietorship is greater than
the net value of the assets and liabiliIes being contributed,
goodwill is created

Forming a Partnership
Why are assets and liabiliIes taken over at agreed
values?
When a partnership is formed the partners agree on the
values for the items to be contributed. This agreed value
could be the market value, replacement value or book
value. The agreed value must be a fair value.
The agreed value then becomes the historical cost to the
new business because this is the acquisiIon cost to the
new partnership.
For assets, Accumulated DepreciaIon is therefore not
carried forward to the partnership records.

Forming a Partnership
All assets and liabiliIes, except accounts receivable, are
recorded at their new historical cost (their agreed value).
How are Accounts Receivable recorded?
Accounts Receivable are recorded at historical cost in the
new partnership and an Allowance for Doubiul Debts will
be created when the agreed value is less than historical
cost. This is because the partnership has a claim to the
debtors total amount and it must be disclosed. The
Allowance for Doubiul Debts recognises that the
partnership may expect future losses from debtors.

Forming a Partnership
Example of how Accounts Receivable is recorded
Business that is being contributed to the partnership:
Accounts Receivable

12 000

less allowance for doubtful debts

2 000
10 000

It is agreed that the Accounts Receivable will be taken over


original
at $8,000.
amount
Accounts Receivable

12 000

Allowance for Doubtful Debts

difference between original amount


and agreed value

4 000

Forming a Partnership
Example of a journal entry for one partner contribuIng
an exisIng business and one partner contributes cash.
Accounts Receivable
Inventory
Property
100,000
Equipment
67,000
Goodwill
Allowance for Doubtful Debts
Accounts Payable
agreed
Loan
value of the
business
Capital Partner A
Bank
Capital Partner B

12 000
15 000
50 000
25 000
33 000
4 000
6 000
25 000
100 000
50 000
50 000

Forming a Partnership
GOODWILL
Goodwill is the dierence between the agreed value
contributed by the partner/s and the agreed value of
the net assets that are taken over by the partnership.

Goodwill = Net Assets Agreed Capital figure
What does Goodwill represent?
The value placed on the enItys reputaIon, loyal
customers, and quality of service that are
immediately protable thus providing future
economic benets for the partnership.

Forming a Partnership
When one partner contributes a business, the other
partner may want to contribute cash that is in
proporIon to the value of the sole proprietorship
business being contributed.
For example:
Partner A contributes a business valued at $150,000. Partner B
wants to be of the TOTAL equity of the partnership.

Partner A - $150,000
Partner B will contribute $50,000 so that
his share is 1/4

During the financial year


During the nancial year, a partner or partners may
contribute more cash in to the business.

Bank

Capital Partner A

Debit

Credit

xx

xx

The interest on capital that a partner receives is o6en


based on an average capital account balance over the
year or the closing capital account balance, to take in to
account any capital contribuIons during the year.

Partnership Year End


At the end of the nancial year, the partnership
prepares an Income Statement to calculate prot.

Trial
Balance

Process the
Balance Day
Adjustments

Income Statement to
calculate profit

Adjusted
Trial
Balance

Partnership Year End


BALANCE DAY ADJUSTMENTS

prepayments
accrued expenses
income in advance
accrued income
invoices on hand on balance day
depreciation
bad debts
doubtful debts
write down of inventory

Partnership Year End


INCOME STATEMENT SERVICE PARTNERSHIP
$

Revenue
State primary source of income (1)
Add other income (2)
(list)
Less Expenses
Group One expenses (3)
(list)
Administrative expenses
(list)
Finance costs
(list)
Total expenses
Profit (loss) for the year

xxx
xx
xx

xx
xx

xxx

xx
xx

xxx

xx
xx

xxx

xxx
xxx

xxx
$ xxx

Partnership Year End


INCOME STATEMENT TRADING PARTNERSHIP

Revenue
Sales
Less Sales Returns
Net Sales
Less Cost of goods sold
Gross profit
Add Other income
(list)

xx
xx
xxx
xx
xxx
xx
xxx

Less Expenses
Distribution costs
(list)
Administrative expenses
(list)
Finance costs
(list)
Total expenses
Profit (loss) for the year

xx

xx

xx

xx

xx

xx
xxx
$ xxx

Partnership Year End


Once the Income Statement has been completed and
the prot has been calculated, the prot (or loss) needs
to be shared out to the partners based on the prot
sharing clauses in the Partnership Agreement.

The prot sharing is detailed in the nancial report
called the PROFIT DISTRIBUTION STATEMENT

Profit Distribution Statement


Prot for the year


Add: Interest on Drawings Partner A



Partner B
Interest on Current Partner A
Less: Interest on Capital Partner A
Interest on Capital Partner B
Salary Partner A

Salary Partner B

Interest on Current Partner B
Prot Share Partner A

Prot Share Partner B

xxx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx

Profit Sharing Journal entries


Transfer of Prot from Income Statement to Prot
DistribuIon Statement (to then be shared out to
partners according to the clauses in the Partnership
Agreement)


Income Summary

Profit Distribution

Debit

Credit

xx

xx

Profit Sharing Journal entries


Transfer of Interest on Drawings
Debit

Credit

Current Account Partner A


xx

Current Account Partner B

xx

Profit Distribution

xx

Profit Sharing Journal entries


Transfer of Interest on Current where the partners
current account has a negaIve (debit) balance


Current Account Partner A

Profit Distribution

Debit

Credit

xx

xx

Profit Sharing Journal entries


Transfer of Interest on Current where the partners
current account has a posiIve (credit) balance


Profit Distribution

Current Account Partner B

Debit

Credit

xx

xx

Profit Sharing Journal entries


Transfer of Interest on Capital


Profit Distribution

Capital Account Partner A

Capital Account Partner B

Debit

Credit

xx

xx

xx

Profit Sharing Journal entries


Transfer of Salary


Profit Distribution

Current Account Partner A

Current Account Partner B

Debit

Credit

xx

xx

xx

Profit Sharing Journal entries


Transfer of Prot Share


Profit Distribution

Current Account Partner A

Current Account Partner B

Debit

Credit

xx

xx

xx

Partnership Equity Accounts


Each partner has a capital and a current account.
They are both equity accounts so are CREDIT accounts.

The
capital account records the iniIal capital

contribuIon the partner made and any subsequent
capital contribuIons.

The current account records the prot distribuIons for
each partner AND their drawings for the year.

Partnership Equity Accounts


CAPITAL ACCOUNT
Date
Balance


Bank / Assets/
Current Account
transfer

XX Cr

XX

XX Cr

Partnership Equity Accounts


CURRENT ACCOUNT

Date

Balance





end
Salaries



XX



Interest on Capital



XX



Interest on Current

XX or

XX



Interest on Drawings
XX





Profit Share



XX



Drawings

XX



partners
drawings
for the year

all come from the profit


distribution statement

XX Cr

XX Cr

XX Cr

XX Cr

XX Cr

XX Cr

XX Cr

Drawings
During the year each partner may take drawings from
the partnership. Drawings are recorded over the year
in the Drawings account. At the end of the year
drawings is closed o to the partners current account.
Drawings REDUCES their equity in the partnership. The
current account is DEBITED.
Journal entry for the transfer of drawings to the
partners current account:


Debit
Credit

Current Account Partner A

xx



Drawings Partner A

xx

Current Account Transfer


Partners with considerably large current account
balances (in credit) may choose to transfer some of
their current account balance to their capital account.
Their overall equity in the partnership will stay the
same.


Debit
Credit

Current Account Partner A

Capital Account Partner A

xx

xx

Statement of Financial Position


Once the equity accounts for the partners are updated,
the Statement of Financial PosiIon with accompanying
notes can be prepared.

Statement of Financial Position


Current assets
Accounts Receivable
(list others)
Non-current assets
Investments
Eg Shares in ABC Ltd
Property, plant and equipment
Intangible asset
Eg Goodwill
Total assets
Less Liabilities
Current liabilities
(list)

Note

xx
xx
xx
xx

xxx

2
3

xx
xx
xx

xxx
xxx

xx
xx

xxx

Statement of Financial Position


Non-current liabilities
(list)
Total liabilities
Net assets
Equity
Capital
Current

Note

xx

xxx

xxx
$ xxx
5
xx
xx

$ xxx

Notes to Statement of Financial


Position
1. Accounts Receivable
Accounts Receivable
Less Allowance for doubtful debts

5,000
100
$4,900

2. Investments
Investments comprise shares in (eg ABC Ltd). The current fair
value of the shares is (eg $7,200) which is their market value on
31 March 2.
Or
Investments are in Government Stock / a Fixed Term Deposit with
an interest rate of x% and a maturity date of


Notes to Statement of Financial


Position
3. Property, Plant and Equipment

For year ended 31


March 2
Opening carrying
amount
Plus additions
Less disposals
Less depreciation
Closing carrying
amount
As at 31 March 2
Cost
Accumulated
depreciation
Carrying amount

Land

Equipment

Vehicles

Total

60,000

19,200

32,000

111,200

20,000
0
0

0
0
(2,400)

16,000
(14,000)
(3,600)

36,000
(14,000)
(6,000)

$ 80,000

$ 16,800

$30,400

$127,200

80,000

24,000

36,000

140,000

(7,200)

(5,600)

(12,800)

$80,000

$16,800

$30,400

$127,200

DepreciaIon is calculated on a straight-line basis at the following


rates: Equipment 10% pa Vehicles 20% pa

Notes to Statement of Financial


Position

4. Loan / Mortgage
The loan / mortgage has an interest rate of x% and a maturity
date of

5. Equity

Partner A
Partner B
Total

Capital

Current

Total

X
X
X

X
X
X

X
X
X

Profit Sharing Clauses - reasons


Clause

Reason

Interest The purpose of rewarding partners with interest on


on
capital is to encourage them to invest more economic
Capital benets into the business, as they know they will
make a return on their investment each year. This
would benet the business as the investment can be
used for business expansion or improvements, which
could eventually result in the business becoming
more protable which benets for the partners.
Also, partners should be rewarded in proporIon to
their capital investment to reect the fact that a
partner with a higher capital investment has a bigger
risk than those with a smaller capital investment.

Profit Sharing Clauses - reasons


Clause

Reason

Interest
on
Current

A credit-balanced current account would be credited with


interest to encourage the partners to retain some prot in the
business rather than invesIng it somewhere else outside the
business (such as a bank deposit). By retaining cash in the
business, the business can use the money to improve or expand.
Debit-balanced current accounts are charged interest as a debit
balance. Being charged interest should discourage partners from
incurring a debit/negaIve current account balance, potenIally
increasing the cash available for the partnership to improve and
expand.

Salary

Salaries as a prot distribuIon, reect the dierent roles and


responsibiliIes each partner has in the business.

Profit Sharing Clauses - reasons


Clause

Reason

Interest
The purpose of charging interest on drawings (eg
on
10%) is to discourage partners from taking cash out
Drawings of the business for personal use. The high interest
rate (compared with interest earned on capital and
current accounts) will discourage the partners from
taking large amounts of drawings as they will not
want to pay the 10% interest. By applying a 10%
interest rate on drawings, and therefore reducing
the amount of drawings, more cash is retained in
the business to use for expansion and
improvement.

Profit Sharing Clauses - reasons


Clause

Reason

Bonus

The purpose of rewarding one (or more) partners with


a bonus for sales over a signicant amount is to
provide the partner(s) with an incenIve to work hard
and earn the business more sales. Both partners will
benet from increased sales gures, as prots will
increase also, meaning both partners will receive
more prot.

Profit Sharing Clauses - reasons


Clause

Reason

Residual The Partnership Act 1908 states that all prots are
Prot/Loss to be shared equally between partners. O6en
partners opt to alter this clause in their
personalised Partnership Agreement to show that
they wish to distribute residual prots in the
manner that they see most t and fair which is
o6en the iniIal capital invested by each partner.
Rewarding each partner dependant on their capital
investment reects the fact that more capital is
more risk for the partner and they should therefore
be rewarded accordingly.

Profit Sharing Clauses - AS 3.2


The
internal achievement standard 3.2 requires students

to:

Achievement - Demonstrate understanding involves

applying partnership accounIng elements to enable the
partnership to conInue operaIons.
Merit - Demonstrate in-depth understanding involves
explaining the applicaIon of partnership accounIng
elements to enable the partnership to conInue operaIons.
Excellence - Demonstrate comprehensive understanding
involves jusIfying the applicaIon of partnership
accounIng elements to enable the partnership to conInue
operaIons

Profit Sharing Clauses - AS 3.2




Achieved:
What
Merit:

Why
Excellence:
How and Consequence

So when wriIng about prot sharing clauses, the
answer needs to explain:
what it is and does
why is it important
how does it help the business moving forward
consequence of not having it or possible
consequences of having it

Profit Sharing Clauses - AS 3.2


EXAMPLE

Jim
is a partner in the business Neverland Adventures.

Explain why the Partnership Agreement for Neverland

Adventures would have the following clause:

Interest on drawings 10% over agreed salaries agreed
salary for Jim
Jims Salary is $50,000
Jims Drawings for 2012: $60,000
Interest on drawings: $1,000

Profit Sharing Clauses - AS 3.2




What
(it is and does): An interest charge of 10%

will
be charged to Jim if his Drawings exceed his

agreed salary. So, because he withdrew $10 000


more than $50 000 his interest charge will be
$1 000. This will be subtracted/debited from his
current account which decreases his equity in the
Partnership.

Profit Sharing Clauses - AS 3.2




Why
(is it important): The reason for this

interest charge is to discourage partners such as


Jim from taking excessive drawings over his
agreed salary of $50 000.

Profit Sharing Clauses - AS 3.2




How
(does it help the business moving forward):

This
will help the business because it enables the

partnership to maintain a posiIve cashow and


encourages Jim to retain capital in the business
for future expansion. The business will also not
be adversely aected from achieving its goals
through partners not following the Partnership
Agreement.

Profit Sharing Clauses - AS 3.2



Consequence (e.g. consequence of not having it

or possible consequences of having it): The

consequence of not having the clause for the


Partnership is that there will be no deterrent for
Partners from taking excessive drawings so
partners could be inclined to withdrawal too
much which signicantly aects working capital
and cashow for future expansion or paying
creditors.