Principles of financial accounting 12e by needles crosson chapter 12

CHAPTER 12 Accounting for Partnerships Principles of Accounting 12e Needles Powers Crosson ©human/iStockphoto Concepts Underlying Partnerships  A partne rs hip, 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 s e parate e ntitie s , with their own accounting records and financial statements – Legally, there is no economic separation between a partnership and its owners ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Characteristics of Partnerships (slide of 3)  Voluntary association—A partnership is a voluntary association of individuals Therefore, a partner is legally responsible for his or her partners’ actions within the scope of the business  Partnership agreement—Although not required, it is good business practice to have a written partne rs hip ag re e me nt 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Characteristics of Partnerships (slide of 3)  Limited life—A partnership has a limite d life It 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  Mutual agency—Each partner is an agent of the partnership within the scope of the business Because of this mutual ag e nc y, any partner can bind the partnership to a business agreement as long as he or she acts within the scope of the company’s normal operations ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Characteristics of Partnerships (slide of 3)  Unlimited liability—Each partner has personal unlimite d 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  Co-ownership of partnership property—When individuals invest property in a partnership, the property becomes an asset of the partnership and is owned jointly by the partners  Participation in partnership income—Each partner has the right to share in the partnership’s income and the responsibility to share in its losses ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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  Disadvantages – 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 partne rs ’ e quity – 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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:  Return to the partners for the use of their capital (called inte re s t on partne rs ’ capital)  Compensation for services the partners have rendered  Other income for any special contributions individual partners may make to the partnership or for risks they may take ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Dissolution of a Partnership  Dis s o lutio n 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 conce rn – 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 agreement – An individual can be admitted to a partnership in one of two ways:  Purchasing an interest in the partnership from one or more of the original partners  Investing assets in the partnership ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 bo nus to the original partners – The bonus must be distributed to the original partners according to the partnership agreement or, if the agreement does not cover the distribution of bonuses, in accordance with the method for distributing income and losses ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Liquidation of a Partnership  The liquidatio n 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Limited Partnerships  A limite d partne rs hip (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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Joint Ventures  A jo int ve nture is an association of two or more entities for the purpose of achieving a specific goal, such as the manufacture of a product in a new market – Most joint ventures have an agreed-upon limited life – Profits and losses are shared on an agreed-upon basis – J oint ventures frequently take the form of partnerships between two or more corporations and other investors – They are often used by U.S companies that want ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Companies That Look Like Partnerships  S c o rpo ratio ns —corporations that U.S tax laws treat as partnerships – Unlike normal corporations, they 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  Limite d liability c o mpany (LLC)—companies whose members are partners, but their liability is limited to their investment in the business  S pe c ial-purpo s e e ntitie s (S PEs )—firms with limited lives that a company creates to achieve a specific objective, such as raising money by selling receivables ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part  ... 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,... Partnerships  A partne rs hip, 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 s... part Characteristics of Partnerships (slide of 3)  Unlimited liability—Each partner has personal unlimite d liability for all the debts of the partnership If the assets of the business are not