Understanding the Key Characteristics and Operations of Partnerships

BAT4M University/College Grade 12 Accounting Chapter 12 Study Notes Characteristics of Partnerships 1. 2. 3. 4. 5. 6. Co-ownership of property Association of individuals Unlimited liability Limited life Mutual agency Division of income Co-ownership of Property – Assets are owned jointly by partners – When a partnership dissolves, assets are not restored to the initial contributor; instead, gains and losses are divided among the partners. Association of Individuals – partnerships can be formed legally or casually – partnerships can be legal entities – assets can be owned in the name of the partnership – partnerships cannot be taxed as a separate entity Unlimited Liability – each partner is liable for all partnership liabilities – anything one partner does, the other partner is responsible for Limited Life – any change in ownership ends the partnership – partnership dissolution occurs when a partner withdraws or a new partner is admitted – if continuing partners agree, operations can continue without interruption by forming a new partnership Mutual Agency – any actions one partner does are bonded to the other partners – each partner acts on behalf of the others when they are doing business Division of Net Income – net income/loss must be divided between partners – the amount divided is based on an income ratio previously determined Limited Partnerships – if a partner has unlimited liability, they are called a general partner – if a partner has limited liability, they are called a limited partner – limited partnerships have at least one of each type of partner – most frequently employed by companies that provide tax shelters for investors, real estate, rental properties, and sports endeavors Limited Liability Partnerships – protects innocent partners from possible liabilities – partners have unlimited liability for their own actions but have limited liability for the actions of other partners – partners are also liable for actions of employees they supervise/control Pros & Cons of a Partnership Benefits include easier formation, fewer government laws and constraints, the ability to make decisions quickly, and the combining of resources and abilities from several people. Disadvantages: mutual agency, limited life, unlimited liability Partnership Agreement – written contract between partners – features additional information including rights, duties, and income ratio – if no partnership agreement is created, the partnership act will apply Forming a Partnership – initial investments by partners must be recorded at fair market value – journal entries are made to establish initial investments Dividing Net Income/Net Loss – shared equally unless otherwise indicated by an income ratio – closing entries are the same except net income/loss needs to be allocated to different accounts based on the income ratio – drawings must also be in separate accounts Closing Entries 1. 2. 3. 4. close revenue accounts close expense accounts appropriately divide net income/loss and apply the changes close drawings Income Ratios – income should be shared in a way that fairly reflects each partner’s investment and service to the business – income ratios may not necessarily be used to calculate income ratios – can be: fixed ratios, ratio based on capital balances, salaries to partners and the remainder in a fixed ratio, interest on capital balances and remainder in a fixed ratio, and salaries to partners, interest on capital balances, and remainder in a fixed ratio Salaries, Interest & Remainder in a Fixed Ratio – salaries are distributed, then interest distributed, and remainder issued last – entry for remainder: DR Income Summary, CR Capital Accounts – entry for negative remainder: DR Capital Accounts, CR Income Summary Partnership Financial Statements – similar to that of a proprietorship but with a few changes – division of net income/loss is often a separate schedule or note to the statement – this statement of equity is known as the statement of partners’ capital – illustrates changes in capital accounts – equity section of balance sheet is known as the section called partners’ equity Admission of a Partner – legally dissolves previous partnership and begins a new one – partners may be admitted through the purchase of the interest of an existing partner or investing assets in the partnership – purchase of the interest of a partner involves a capital transfer among partners – total capital is not affected by this – investing assets increases net assets and total capital Purchase of Interest – admission by purchase of an interest is a personal transaction that does not change capital of the business – the purchase amount of interest is negotiated between the new partner and old partner – entry is simple: DR old capital account, CR new capital account Investment of Assets – admission by investment increases net assets and total capital – if investment matches capital equity, DR cash/asset, CR capital – new partner may need to provide a bonus to old partners to accommodate for goodwill/reputation 1. determine total capital of new partnership (add new partner’s investment to the total capital of the old partnership) 2. determine new partner’s capital credit (multiply total capital of the new partnership by the new partner’s ownership interest) 3. determine amount of bonus (subtract new partner’s capital from new partner’s investment) 4. distribute bonus to the old partners based on their income ratios – to record bonus to old partners: DR cash/asset, CR old partner’s capital, new partner’s capital – new partner may receive a bonus from old partners because they have skills/resources needed by the partnership – bonus to new partner involves decrease of old partners’ capital accounts based on the income ratio 1. determine total capital of new partnership 2. determine new partner’s capital credit (multiply total capital by new partner’s ownership interest) 3. determine amount of bonus (subtract new partner’s capital from new partner’s investment) 4. distribute bonus to old partners (debit their capital accounts based on the income ratio) Withdrawal of a Partner – withdrawals can occur when they sell their equity or retire/die – the withdrawal of a partner dissolves the partnership – can be done by payment from partners’ personal assets or a payment from partnership assets – payment from personal assets only affects capital accounts – payment from partnership assets decreases net assets and total capital of the partnership – income ratios must be reviewed and re-specified once a partner withdraws Payment from Partner’s Personal Assets – personal transaction between partners – opposite of admitting a new partner who purchases interest Payment from Partnership Assets – both net assets and total capital are decreased – opposite of admitting a partner through investment of assets Bonus to Leaving Partner – occurs when: fair market value of partnership assets is more than NBV, there is unrecorded goodwill, or the remaining partners are anxious to remove the partner – bonus to leaving partner is deducted from capital accounts of staying partners 1. determine amount of bonus (subtract departing partner’s capital from cash paid by the partnership) 2. distribute bonus to staying partners (debit their capital balances based on income ratios) Bonus to Remaining Partners – occurs when: assets are overvalued, partnership has a poor earnings record, or partner is anxious to leave the partnership – bonus to remaining partners is credited to their capital accounts 1. determine amount of bonus (subtract leaving partner’s capital from cash paid by the partnership) 2. distribute bonus to remaining partners based on their income ratios Death of a Partner – dissolves the partnership – net income/loss for the year must be calculated, books must be closed, and financial statements must be prepared – remaining partners have the option of either paying from personal assets or paying from partnership assets Liquidation of a Partnership – ends both legal and economic life of the partnership – sale of non-cash assets for cash is called realization – any difference between NBV and proceeds is called the gain/loss on realization 1. 2. 3. 4. sell non-cash assets for cash and recognize any gain/loss on realization allocate gain/loss on realization to partners based on income ratio pay liabilities in cash distribute remaining cash to partners – creditors must be paid before partners receive any cash – no capital deficiency occurs when there are credit capital balances – capital deficiency occurs when there are debit capital balances Capital Deficiency 1. realization of non-cash assets is recorded 2. loss on realization is allocated to partners based on their income ratio 3. liabilities are paid – if payment of deficiency is paid, then DR cash, CR capital of the partner with debit balance – if payment of deficiency is not paid, then the partners with credit balance must absorb the deficiency based on their income ratio – DR capital accounts with credit balances, CR capital account(s) with debit balances