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Find more at www.downloadslide.com 12 Accounting for Partnerships CHAPTER PREVIEW It is not surprising that when Cliff Chenfeld and Craig Balsam began Razor & Tie (see the Feature Story below), they decided to use the partnership form of organization. Both saw the need for hands-on control of their product and its promotion. In this chapter, we discuss reasons why businesses select the partnership form of organization. We also explain the major issues in accounting for partnerships. FEATURE STORY From Trials to the Top Ten In 1990, Cliff Chenfeld and Craig Balsam gave up the razors, In 1995, Razor & Tie broke into the contemporary music world ties, and six-figure salaries they had become accustomed to as with Living in the ’90s, the most successful record in the New York lawyers. Instead, they set up a partnership, Razor & history of the company. Featuring a number of songs that Tie Music, in Cliff’s living room. Ten years later, it became the were still hits on the radio at the time the package initially only record company in the country that had achieved success aired, Living in the ’90s was a blockbuster. It received Gold in selling music both on television and in stores. Razor & Tie’s certification in less than nine months and rewrote the rules on entertaining and effective TV commercials have yielded direct-response albums. For the first time, contemporary music unprecedented sales for multi-artist music compilations. At was available through an album offered only through the same time, its hot retail label has been behind some of the direct-response spots. most recent original, progressive releases from artists such as Norma Jean, For Today, Chelsea Grin, and Starset. In fact, Razor & Tie is now a vertically integrated business that includes a music company with major label distribution, a Razor & Tie got its start with its first TV release, Those music publishing business, a media buying company, a home Fabulous ’70s (100,000 copies sold), followed by Disco Fever video company, a direct marketing operation, and a growing (over 300,000 sold). After restoring the respectability of the database of entertainment consumers. oft-maligned music of the 1970s, the partners forged into the musical ’80s with the same zeal that elicited success with their first releases. In 1993, Razor & Tie released Totally ’80s, a collection of Top-10 singles from the 1980s that has sold over 450,000 units. 532 Razor & Tie has carved out a sizable piece of the market through the complementary talents of the two partners. Their imagination and savvy, along with exciting new releases planned for the coming years, ensure Razor & Tie’s continued growth. Find more at www.downloadslide.com Ollyy/Shutterstoc O Oll lyyy/ yyy/ y Shu Sh tte t erst tt rst rs rstoc s oc o CHAPTER OUTLINE 1 Discuss and account for the formation of a partnership. • Characteristics of partnerships • Organizations with partnership characteristics • Advantages and disadvantages of partnerships • The partnership agreement • Accounting for a partnership formation 2 Explain how to account for net income or net loss of a partnership. • Dividing net income or net loss • Partnership financial statements 3 Explain how to account for the liquidation of a partnership. • No capital deficiency • Capital deficiency Learning Objectives Partnership DO IT! 1 Organization DO IT! 2 Division of Net Income 3a Partnership Liquidation— DO IT! No Capital Deficiency 3b Partnership Liquidation— Capital Deficiency Go to the REVIEW AND PRACTICE section at the end of the chapter for a review of key concepts and practice applications with solutions. Visit WileyPLUS with ORION for additional tutorials and practice opportunities. Find more at www.downloadslide.com 534 12 Accounting for Partnerships LEARNING OBJECTIVE 1 Discuss and account for the formation of a partnership. A partnership is an association of two or more persons to carry on as co-owners of a business for profit. Partnerships are sometimes used in small retail, service, or manufacturing companies. Accountants, lawyers, and doctors also find it desirable to form partnerships with other professionals in the field. Characteristics of Partnerships Partnerships are fairly easy to form. People form partnerships simply by a verbal agreement or more formally by written agreement. We explain the principal characteristics of partnerships in the following sections. Association of Individuals Mutual Agency Limited Life ASSOCIATION OF INDIVIDUALS A partnership is a legal entity. A partnership can own property (land, buildings, equipment) and can sue or be sued. A partnership also is an accounting entity. Thus, the personal assets, liabilities, and transactions of the partners are excluded from the accounting records of the partnership, just as they are in a proprietorship. The net income of a partnership is not taxed as a separate entity. But, a partnership must file an information tax return showing partnership net income and each partner’s share of that net income. Each partner’s share is taxable at personal tax rates, regardless of the amount of net income each withdraws from the business during the year. MUTUAL AGENCY Mutual agency means that each partner acts on behalf of the partnership when engaging in partnership business. The act of any partner is binding on all other partners. This is true even when partners act beyond the scope of their authority, so long as the act appears to be appropriate for the partnership. For example, a partner of a grocery store who purchases a delivery truck creates a binding contract in the name of the partnership, even if the partnership agreement denies this authority. On the other hand, if a partner in a law firm purchased a snowmobile for the partnership, such an act would not be binding on the partnership. The purchase is clearly outside the scope of partnership business. LIMITED LIFE Corporations have unlimited life. Partnerships do not. A partnership may be ended voluntarily at any time through the acceptance of a new partner or the withdrawal of a partner. It may be ended involuntarily by the death or incapacity of a partner. Partnership dissolution occurs whenever a partner withdraws or a new partner is admitted. Dissolution does not necessarily mean that the business ends. If the continuing partners agree, operations can continue without interruption by forming a new partnership. UNLIMITED LIABILITY Each partner is personally and individually liable for all partnership liabilities. Creditors’ claims attach first to partnership assets. If these are insufficient, the claims then attach to the personal resources of any partner, irrespective of that partner’s equity in the partnership. Because each partner is responsible for all the debts of the partnership, each partner is said to have unlimited liability. Unlimited Liability CO-OWNERSHIP OF PROPERTY Partners jointly own partnership assets. If the partnership is dissolved, each partner has a claim on total assets equal to the balance in his or her respective capital account. This claim does not attach to specific assets that an individual partner Find more at www.downloadslide.com Forming a Partnership contributed to the firm. Similarly, if a partner invests a building in the partnership valued at $100,000 and the building is later sold at a gain of $20,000, the partners all share in the gain. Partnership net income (or net loss) is also co-owned. If the partnership contract does not specify to the contrary, all net income or net loss is shared equally by the partners. As you will see later, though, partners may agree to unequal sharing of net income or net loss. 535 TOR Ltd. Co-Ownership of Property Organizations with Partnership Characteristics If you are starting a business with a friend and each of you has little capital and your business is not risky, you probably want to use a partnership. As indicated above, the partnership is easy to establish and its cost is minimal. These types of partnerships are often called regular partnerships. However if your business is risky—say, roof repair or performing some type of professional service—you will want to limit your liability and not use a regular partnership. As a result, special forms of business organizations with partnership characteristics are now often used to provide protection from unlimited liability for people who wish to work together in some activity. The special partnership forms are limited partnerships, limited liability partnerships, and limited liability companies. These special forms use the same accounting procedures as those described for a regular partnership. In addition, for taxation purposes, all the profits and losses pass through these organizations (similar to the regular partnership) to the owners, who report their share of partnership net income or losses on their personal tax returns. LIMITED PARTNERSHIPS In a limited partnership, one or more partners have unlimited liability and one or more partners have limited liability for the debts of the firm. Those with unlimited liability are general partners. Those with limited liability are limited partners. Limited partners are responsible for the debts of the partnership up to the limit of their investment in the firm. International The words “Limited Partnership,” “Ltd.,” or “LP” identify this type Note of organization. For the privilege of limited liability, the limited partner Much of the funding for usually accepts less compensation than a general partner and exercises successful new U.S. businesses less influence in the affairs of the firm. If the limited partners get comes from “venture capital” involved in management, they risk their liability protection. firms, which are organized as LIMITED LIABILITY PARTNERSHIP Most states allow professionals such as lawyers, doctors, and accountants to form a limited liability partnership or “LLP.” The LLP is designed to protect innocent partners from malpractice or negligence claims resulting from the acts of another partner. LLPs generally carry large insurance policies as protection against malpractice suits. These professional partnerships vary in size from a medical partnership of three to five doctors, to 150 to 200 partners in a large law firm, to more than 2,000 partners in an international accounting firm. limited partnerships. To develop its own venture capital industry, China has taken steps to model its partnership laws to allow for limited partnerships like those in the United States. LIMITED LIABILITY COMPANIES A hybrid form of business organization with certain features like a corporation and others like a limited partnership is the limited liability company or “LLC.” An LLC usually has a limited life. The owners, called members, have limited liability like owners of a corporation. Whereas limited partners do not actively participate in the management of a limited partnership (LP), the members of a limited liability company (LLC) can assume an active management role. For income tax purposes, the IRS usually classifies an LLC as a partnership. Helpful Hint In an LLP, all partners have limited liability. There are no general partners. Find more at www.downloadslide.com 536 12 Accounting for Partnerships Accounting Across the Organization Limited Liability Companies Gain in Popularity © Daniel Laflor/iStockphoto The proprietorship form of business organization is still the most popular, followed by the corporate form. But whenever a group of individuals wants to form a partnership, the limited liability company is usually the popular choice. One other form of business organization is a subchapter S corporation. A subchapter S corporation has many of the characteristics of a partnership—especially taxation as a partnership—but it is losing its popularity. The reason: It involves more paperwork and expense than a limited liability company, which in most cases offers similar advantages. Why do you think that the use of the limited liability company is gaining in popularity? (Go to WileyPLUS for this answer and additional questions.) Illustration 12-1 summarizes different forms of organizations that have partnership characteristics. Illustration 12-1 Different forms of organizations with partnership characteristics Major Advantages Major Disadvantages Regular Partnership Simple and inexpensive to create and operate. Owners (partners) personally liable for business debts. Limited partners have limited personal liability for business debts as long as they do not participate in management. General partners personally liable for business debts. General Partners Limited Partnership General Partner Limited Partners Limited Liability Partnership General partners can raise cash without involving outside investors in management of business. Mostly of interest to partners in old-line professions such as law, medicine, and accounting. Owners (partners) are not personally liable for the malpractice of other partners. More expensive to create than regular partnership. Suitable mainly for companies that invest in real estate. Unlike a limited liability company, owners (partners) remain personally liable for many types of obligations owed to business creditors, lenders, and landlords. Often limited to a short list of professions. Limited Liability Company Owners have limited personal liability for business debts even if they participate in management. Source: www.nolo.com. More expensive to create than regular partnership. Find more at www.downloadslide.com Forming a Partnership 537 Advantages and Disadvantages of Partnerships Why do people choose partnerships? One major advantage of a partnership is to combine the skills and resources of two or more individuals. In addition, partnerships are easily formed and are relatively free from government regulations and restrictions. A partnership does not have to contend with the “red tape” that a corporation must face. Also, partners generally can make decisions quickly on substantive business matters without having to consult a board of directors. On the other hand, partnerships also have some major disadvantages. Unlimited liability is particularly troublesome. Many individuals fear they may lose not only their initial investment but also their personal assets if those assets are needed to pay partnership creditors. Illustration 12-2 summarizes the advantages and disadvantages of the regular partnership form of business organization. As indicated previously, different types of partnership forms have evolved to reduce some of the disadvantages. Advantages Disadvantages Combining skills and resources of two or more individuals Ease of formation Freedom from governmental regulations and restrictions Ease of decision-making Mutual agency Limited life Unlimited liability Illustration 12-2 Advantages and disadvantages of a partnership The Partnership Agreement Ideally, the agreement of two or more individuals to form a partnership should be expressed in a written contract, called the partnership agreement or articles of co-partnership. The partnership agreement contains such basic information as the name and principal location of the firm, the purpose of the business, and date of inception. In addition, it should specify relationships among the partners, such as: 1. Names and capital contributions of partners. 2. Rights and duties of partners. 3. Basis for sharing net income or net loss. 4. Provision for withdrawals of assets. 5. Procedures for submitting disputes to arbitration. 6. Procedures for the withdrawal or addition of a partner. 7. Rights and duties of surviving partners in the event of a partner’s death. We cannot overemphasize the importance of a written contract. The agreement should attempt to anticipate all possible situations, contingencies, and disagreements. The help of a lawyer is highly desirable in preparing the agreement. ETHICS NOTE A well-developed partnership agreement specifies in clear and concise language the process by which the partners will resolve ethical and legal problems. This issue is especially significant when the partnership experiences financial distress. Accounting Across the Organization Dividing Up the Pie What should you do when you and your business partner disagree to the point where you are no longer on speaking terms? Given how heated busiPhotoDisc/Getty Images, Inc. ness situations can get, this is not an unusual occurrence. Unfortunately, in many instances the partners do everything they can to undermine each other, eventually destroying the business. In some cases, people even steal from the partnership because they either feel that they “deserve it” or they assume that the other partners are stealing from them. It would be much better to follow the example of Jennifer Appel and her partner. They found that after opening a successful bakery and writing a cookbook, they couldn’t agree on how the business should be run. The other partner bought out Ms. Appel’s share of the business. Ms. Appel went on to start her own style of bakery, which she ultimately franchised. Source: Paulette Thomas, “As Partnership Sours, Parting Is Sweet,” Wall Street Journal, (July 6, 2004), p. A20. How can partnership conflicts be minimized and more easily resolved? (Go to WileyPLUS for this answer and additional questions.) Find more at www.downloadslide.com 538 12 Accounting for Partnerships Accounting for a Partnership Formation We now turn to the basic accounting for partnerships. The major accounting issues relate to forming the partnership, dividing income or loss, and preparing financial statements. When forming a partnership, each partner’s initial investment in a partnership is entered in the partnership records. The partnership should record these investments at the fair value of the assets at the date of their transfer to the partnership. All partners must agree to the values assigned. To illustrate, assume that A. Rolfe and T. Shea combine their proprietorships to start a partnership named U.S. Software. The firm will specialize in developing financial modeling software. Rolfe and Shea have the following assets prior to the formation of the partnership. Illustration 12-3 Book and fair values of assets invested Items under owners’ equity (OE) in the accounting equation analyses are not labeled in this partnership chapter. Nearly all affect partners’ capital accounts. A 5 L 1 OE 18,000 14,000 112,000 Cash Flows 18,000 A 5 L 1 OE 19,000 14,000 21,000 112,000 Cash Flows 19,000 Book Value Cash Equipment Accumulated depreciation—equipment Accounts receivable Allowance for doubtful accounts Fair Value A. Rolfe T. Shea A. Rolfe T. Shea $ 8,000 5,000 (2,000) $ 9,000 $ 8,000 4,000 $ 9,000 4,000 (700) $11,000 $12,300 4,000 (1,000) $12,000 $12,000 The partnership records the investments as follows. Investment of A. Rolfe Cash Equipment A. Rolfe, Capital (To record investment of Rolfe) 8,000 4,000 12,000 Investment of T. Shea Cash Accounts Receivable Allowance for Doubtful Accounts T. Shea, Capital (To record investment of Shea) 9,000 4,000 1,000 12,000 Note that the partnership records neither the original cost of the equipment ($5,000) nor its book value ($5,000 2 $2,000). It records the equipment at its fair value, $4,000. The partnership does not carry forward any accumulated depreciation from the books of previous entities (in this case, the two proprietorships). In contrast, the gross claims on customers ($4,000) are carried forward to the partnership. The partnership adjusts the allowance for doubtful accounts to $1,000, to arrive at a cash (net) realizable value of $3,000. A partnership may start with an allowance for doubtful accounts because it will continue to collect existing accounts receivable, some of which are expected to be uncollectible. In addition, this procedure maintains the control and subsidiary relationship between Accounts Receivable and the accounts receivable subsidiary ledger. After formation of the partnership, the accounting for transactions is similar to any other type of business organization. For example, the partners record all transactions with outside parties, such as the purchase or sale of inventory and the payment or receipt of cash, the same as would a sole proprietor. The steps in the accounting cycle described in Chapter 4 for a proprietorship also apply to a partnership. For example, the partnership prepares a trial balance Find more at www.downloadslide.com Accounting for Net Income or Net Loss 539 and journalizes and posts adjusting entries. A worksheet may be used. There are minor differences in journalizing and posting closing entries and in preparing financial statements, as we explain in the following sections. The differences occur because there is more than one owner. DO IT! 1 Partnership Organization Indicate whether each of the following statements is true or false. ________ 1. Partnerships have unlimited life. Corporations do not. ________ 2. Partners jointly own partnership assets. A partner’s claim on partnership assets does not attach to specific assets. Action Plan ________ 3. In a limited partnership, the general partners have unlimited liability. ✔ When forming a ________ 4. The members of a limited liability company have limited liability, like shareholders of a corporation, and they are taxed like corporate shareholders. ________ 5. Because of mutual agency, the act of any partner is binding on all other partners. Solution 1. False. Corporations have unlimited life. Partnerships do not. 2. True. 3. True. 4. False. The members of a limited liability company are taxed like partners in a partnership. 5. True. Related exercise material: E12-1 and LEARNING OBJECTIVE 2 DO IT! 12-1. business, carefully consider what type of organization would best suit the needs of the business. ✔ Keep in mind the new, “hybrid” organizational forms that have many of the best characteristics of partnerships and corporations. Explain how to account for net income or net loss of a partnership. Dividing Net Income or Net Loss Partners equally share partnership net income or net loss unless the partnership contract indicates otherwise. The same basis of division usually applies to both net income and net loss. It is customary to refer to this basis as the income ratio, the income and loss ratio, or the profit and loss (P&L) ratio. Because of its wide acceptance, we use the term income ratio to identify the basis for dividing net income and net loss. The partnership recognizes a partner’s share of net income or net loss in the accounts through closing entries. CLOSING ENTRIES As in the case of a proprietorship, a partnership must make four entries in preparing closing entries. The entries are: 1. Debit each revenue account for its balance, and credit Income Summary for total revenues. 2. Debit Income Summary for total expenses, and credit each expense account for its balance. 3. Debit Income Summary for its balance, and credit each partner’s capital account for his or her share of net income. Or, credit Income Summary, and debit each partner’s capital account for his or her share of net loss. 4. Debit each partner’s capital account for the balance in that partner’s drawings account, and credit each partner’s drawings account for the same amount. The first two entries are the same as in a proprietorship. The last two entries are different because (1) there are two or more owners’ capital and drawings accounts, and (2) it is necessary to divide net income (or net loss) among the partners. Find more at www.downloadslide.com 540 12 A Accounting for Partnerships 5 L 1 OE 232,000 116,000 116,000 To illustrate the last two closing entries, assume that AB Company has net income of $32,000 for 2017. The partners, L. Arbor and D. Barnett, share net income and net loss equally. Drawings for the year were Arbor $8,000 and Barnett $6,000. The last two closing entries are as follows. Dec. 31 Income Summary L. Arbor, Capital ($32,000 3 50%) D. Barnett, Capital ($32,000 3 50%) (To transfer net income to partners’ capital accounts) Cash Flows no effect A 5 L 1 32,000 16,000 16,000 OE 28,000 26,000 18,000 16,000 Dec. 31 L. Arbor, Capital D. Barnett, Capital L. Arbor, Drawings D. Barnett, Drawings (To close drawings accounts to capital accounts) Cash Flows no effect 8,000 6,000 8,000 6,000 Assume that the beginning capital balance is $47,000 for Arbor and $36,000 for Barnett. After posting the closing entries, the capital and drawings accounts will appear as shown in Illustration 12-4. Illustration 12-4 Partners’ capital and drawings accounts after closing L. Arbor, Capital 12/31 Clos. 8,000 D. Barnett, Capital 1/1 Bal. 47,000 12/31 Clos. 16,000 12/31 Bal. 8,000 12/31 Clos. 6,000 55,000 L. Arbor, Drawings 12/31 Bal. 12/31 Clos. 1/1 Bal. 36,000 12/31 Clos. 16,000 12/31 Bal. 46,000 D. Barnett, Drawings 8,000 12/31 Bal. 6,000 12/31 Clos. 6,000 As in a proprietorship, the partners’ capital accounts are permanent accounts. Their drawings accounts are temporary accounts. Normally, the capital accounts will have credit balances, and the drawings accounts will have debit balances. Drawings accounts are debited when partners withdraw cash or other assets from the partnership for personal use. Helpful Hint A proportion such as 4:4:2 has a denominator of 10 (4 1 4 1 2). Thus, the basis for sharing net income or loss is 4/10, 4/10, and 2/10. INCOME RATIOS As noted earlier, the partnership agreement should specify the basis for sharing net income or net loss. The following are typical income ratios. 1. A fixed ratio, expressed as a proportion (6:4), a percentage (70% and 30%), or a fraction (2/3 and 1/3). 2. A ratio based either on capital balances at the beginning of the year or on average capital balances during the year. 3. Salaries to partners and the remainder on a fixed ratio. 4. Interest on partners’ capital balances and the remainder on a fixed ratio. 5. Salaries to partners, interest on partners’ capital, and the remainder on a fixed ratio. The objective is to settle on a basis that will equitably reflect the partners’ capital investment and service to the partnership. A fixed ratio is easy to apply, and it may be an equitable basis in some circumstances. Assume, for example, that Hughes and Lane are partners. Each contributes the same amount of capital, but Hughes expects to work full-time in the partnership and Lane expects to work only half-time. Accordingly, the partners agree to a fixed ratio of 2/3 to Hughes and 1/3 to Lane. A ratio based on capital balances may be appropriate when the funds invested in the partnership are considered the critical factor. Capital ratios may also be equitable when the partners hire a manager to run the business and do not plan to take an active role in daily operations. Find more at www.downloadslide.com Accounting for Net Income or Net Loss 541 The three remaining ratios (items 3, 4, and 5) give specific recognition to differences among partners. These ratios provide salary allowances for time worked and interest allowances for capital invested. Then, the partnership allocates any remaining net income or net loss on a fixed ratio. Salaries to partners and interest on partners’ capital are not expenses of the partnership. Therefore, these items do not enter into the matching of expenses with revenues and the determination of net income or net loss. For a partnership, as for other entities, salaries and wages expense pertains to the cost of services performed by employees. Likewise, interest expense relates to the cost of borrowing from creditors. But partners, as owners, are not considered either employees or creditors. When the partnership agreement permits the partners to make monthly withdrawals of cash based on their “salary,” the partnership debits these withdrawals to the partner’s drawings account. SALARIES, INTEREST, AND REMAINDER ON A FIXED RATIO Under income ratio (5) in the list above, the partnership must apply salaries and interest before it allocates the remainder on the specified fixed ratio. This is true even if the provisions exceed net income. It is also true even if the partnership has suffered a net loss for the year. The partnership’s income statement should show, below net income, detailed information concerning the division of net income or net loss. To illustrate, assume that Sara King and Ray Lee are co-partners in the Kingslee Company. The partnership agreement provides for (1) salary allowances of $8,400 to King and $6,000 to Lee, (2) interest allowances of 10% on capital balances at the beginning of the year, and (3) the remaining income to be divided equally. Capital balances on January 1 were King $28,000, and Lee $24,000. In 2017, partnership net income is $22,000. The division of net income is as shown in Illustration 12-5. Illustration 12-5 Division of net income schedule KINGSLEE COMPANY Division of Net Income For the Year Ended December 31, 2017 Net income $ 22,000 Division of Net Income Salary allowance Interest allowance on partners’ capital Sara King ($28,000 3 10%) Ray Lee ($24,000 3 10%) Total interest allowance Sara King Ray Lee Total $ 8,400 $6,000 $14,400 2,800 2,400 5,200 Total salaries and interest Remaining income, $2,400 ($22,000 2 $19,600) Sara King ($2,400 3 50%) Ray Lee ($2,400 3 50%) Total remainder 11,200 Total division of net income $12,400 8,400 19,600 1,200 1,200 2,400 $9,600 $22,000 Kingslee records the division of net income as follows. Dec. 31 Income Summary Sara King, Capital Ray Lee, Capital (To close net income to partners’ capital) A 5 22,000 L 1 OE 222,000 112,000 19,600 12,400 9,600 Cash Flows no effect