Partnership Accounting

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LEARNING OBJECTIVES

When you have completed this chapter, you should 1. have a better understanding of accounting terminology. 2. understand the general characteristics of a partnership and the importance of each one. 3. be able to calculate the division of profits, prepare the proper journal entries, and prepare the financial statements for a partnership. 4. be able to calculate and prepare the journal entries for the sale of a partnership interest, the withdrawal of a partner, and the addition of a partner. 5. be able to calculate and prepare the journal entries for a partnership that is going out of business.

VOCABULARY account form a balance sheet that shows assets on the left-hand side and liabilities and balance sheet owner’s equity on the right-hand side deficit a deficiency in amount; i.e., in this chapter, a deficit balance in the capital account is an abnormal, or a debit, balance liquidation to settle the accounts and distribute the assets of a business mutual agency the legal ability of a partner to bind the partnership to contracts within the scope of the partnership partnership a voluntary association of two or more legally competent persons who agree to do business as co-owners for profit profit-loss ratio the method chosen by partners for dividing the profits or losses; also called the income and loss sharing ratio realization the conversion of noncash assets to cash unlimited liability each partner is personally liable for the business debts

Introduction

The three common types of business are the proprietorship, the corporation, and the partnership. It is important to note that corporations, though fewer in number than proprietorships or partnerships, transact at least 10 times the business of all other business forms combined. There are advantages and disadvantages to each type of business organization. Partnership Accounting 377

Accounting for a partnership is similar to accounting for a proprietorship except there is more than one owner.

General Partnership Characteristics

General partnerships and limited partnerships are recognized by Canadian law. In this chapter, we will concentrate on general partnerships, which are governed by provincial law and registration requirements, and which have certain characteristics. Following is a discussion of each. Voluntary Association A partnership is a voluntary association of two or more legally competent persons (persons who are of age and sound mental capacity) to carry on as co-owners a business for profit. Because a partnership is based on agreement, no person can be a partner against her or his will. Doctors, accountants, and lawyers frequently form partnerships, and this form of business organization is common in small service and retail businesses. Partnership Agreement Two or more legally competent people may form a partnership. It is best if their agreement is in writing, but it may be expressed verbally. The partnership contract is prepared by a lawyer, though an acccountant may review it. The contract will stipulate, among other things, how partnership income and losses are to be divided among the partners. Taxation A partnership is taxed like a proprietorship. In other words, the partners are taxed based upon the partnership’s net income, not on their withdrawals from the business. Limited Life A partnership is a business carried on by individuals and can not exist separate and apart from those individuals. Should something happen to take away the ability of a partner to contract (death, bankruptcy or lack of legal capacity), the partnership may be terminated. Also, the life of a partnership may be limited by terms in the partnership contract, or it may be terminated by any one of the partners at will. Mutual Agency Mutual agency is the legal ability of each partner, acting as an agent of the business, to enter into and bind it to contracts within the scope of the partnership. For example, Alyce, Ben, and Charlie are partners in an accounting firm. Ben may bind the partnership by contracting to buy a computer for the business, even if the other two partners know nothing of the purchase. They are bound to the contract because a computer is an expected and necessary piece of equipment for an accounting firm. However, the firm would not be bound if Ben should contract to buy land with the expectation that its value would increase because this transaction is considered to be outside the purpose of an accounting business. Partners may agree to limit the power of one or more of the partners to negotiate contracts for the business. Outsiders are bound by this agreement only if they are aware of it. Unlimited Liability Much like in a proprietorship, partners have unlimited liability for their business. Unlimited liability means that each partner is personally liable for the debts of the 378 CHAPTER fourteen

business. When a partnership business is unable to pay its debts, the creditors may sat- isfy their claims from the personal assets of any of the partners. If any one partner can not pay her or his share of the debt, creditors may make their claims against any of the other partners.

Advantages and Disadvantages of a Partnership

A partnership has advantages over other forms of business. By combining the abilities and capital of two or more persons, business potential may be greatly expanded. Also, a partnership is much easier to form than a corporation because an agreement between parties is all that is required. However, there are several disadvantages—limited life, unlimited liability, and mutual agency are among these and pose potential legal problems that must be considered when forming any new partnership.

The Drawing Account

Partnership accounting is the same as accounting for a proprietorship except there are separate capital and drawing accounts for each partner. The fundamental accounting equation (Assets = Liabilities + Owner’s Equity) remains unchanged except that total owners’ equity is the sum of the partners’ capital accounts. Similar to a proprietorship, the partners (owners) do not receive salaries but withdraw assets from the business for their personal needs. Generally, the rules for withdrawals are decided beforehand by the partnership agreement. For example, assume that Partner Arnold withdraws $5,000 from a partnership firm of which he is a member. The journal entry to show this withdrawal is as follows:

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Jan. 15 Arnold, Drawing 500000 Cash 500000 To Record the Withdrawal of Cash

At the end of the accounting period, the drawing accounts of each partner are closed to their individual capital accounts. Following is the journal entry to close the drawing account of Partner Arnold to his capital account.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Jan. 31 Arnold, Capital 500000 Arnold, Drawing 500000 To Record the Closing of Arnold’s Drawing Account to Capital Partnership Accounting 379

Accounting for a partnership requires calculations be made for the division of profits and losses and the preparation of journal entries for the addition or withdrawal of a partner. In addition, special problems must be solved when a partnership is going out of business. Each of these will be discussed in the following paragraphs.

Dividing the Net Income

Remember that partners are owners of the business, not employees, and as such, may divide their net income as they choose. The partnership contract, however, must state how the net income or loss is to be divided. If there is no contract, the law states that profits and losses will be divided equally. The method chosen by the partners for dividing the profits or losses is called the profit-loss ratio. This chapter will discuss a number of methods that may be used. Profits and losses: 1. may be divided equally 2. may be distributed on a fractional basis 3. may be distributed based on amounts invested 4. may be distributed using a fixed ratio 5. may be distributed using a salary allowance with any remaining profits divided equally or using a ratio

Dividing Net Income Equally Partners may divide profits equally. For example, M. Saar, J. Loretto, and S. Abdullah are partners. Saar invested $50,000 in cash and other assets, Loretto invested $30,000 cash, and Abdullah invested $40,000 cash in their accounting firm. The following balance sheet was prepared on December 31 before adjusting and closing entries for the year had been prepared.

Saar, Loretto, and Abdullah, Accountants Balance Sheet December 31, 20XX Assets Cash $8000000 Other Assets 5000000 Total Assets $13000000

Liabilities Accounts Payable $1000000

Owners’ Equity Saar, Capital 5000000 Loretto, Capital 3000000 Abdullah, Capital 4000000 12000000 Total Liabilities and Owners’ Equity $13000000 380 CHAPTER fourteen

Revenues were $96,000 and expenses were $60,000, leaving $36,000 net income to be distributed to the three partners’ capital accounts. Once the amount to be allocated is determined, a closing entry crediting the capital accounts is required. If net income is to be divided equally, the Income Summary account is closed to the capital accounts as follows:

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Income Summary 3600000 Saar, Capital 1200000 Loretto, Capital 1200000 Abdullah, Capital 1200000 To Close Income Summary to Capital

Dividing Net Income Based on Amounts Invested The partners may agree to divide net income using a fraction determined by using the amounts of the original capital investment. The following shows the steps involved in this calculation: 1. Determine the amounts originally invested. Saar $ 50,000 Loretto 30,000 Abdullah 40,000 Total $120,000

2. Determine fractions. (The denominator is the total amount invested, $120,000, and each partner’s individual investment becomes the numerator.)

Profits to be Total Ratio Divided Allocated 50,000 5 Saar = $36,000 = $15,000 120,000 12 30,000 3 Loretto = 36,000 = 9,000 120,000 12 40,000 4 Abdullah = 36,000 = 12,000 120,000 12 Total to be allocated $36,000

The general journal entry to close the Income Summary to the capital accounts is as follows: Partnership Accounting 381

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Income Summary 3600000 Saar, Capital 1500000 Loretto, Capital 900000 Abdullah, Capital 1200000 To Record the Closing of the Income Summary to Capital

Dividing Net Income Using a Fixed Ratio In the partnership agreement, the contract may specify a fixed ratio to be used to divide the profits or losses. For example, Saar, Loretto, and Abdullah decide to use a ratio of 3:2:1, respectively. To use this ratio, convert the ratio into a fraction and multiply it by the net income or loss of the period. The steps for using the ratio to divide the profit are as follows: 1. Determine the fraction from the ratio. Add: 3 + 2 + 1 = 6. Thus, 6 becomes the denominator of the fraction. The numerators are the numbers in the ratio. Saar 3/6 or 1/2 Loretto 2/6 or 1/3 Abdullah 1/6 2. Calculate the distribution amounts.

Profits to be Total Fraction Divided Allocated Saar 1/2 $36,000 = $18,000 Loretto 1/3 $36,000 = 12,000 Abdullah 1/6 $36,000 = 6,000 Total $36,000

The general journal entry to close the Income Summary to the capital accounts is as follows:

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Income Summary 3600000 Saar, Capital 1800000 Loretto, Capital 1200000 Abdullah, Capital 600000 To Record the Closing of the Income Summary to Capital 382 CHAPTER fourteen

Dividing Net Income by Paying Interest on Investments and Salary Allowances Another common way to divide profits is to pay interest on the original capital investments, give a salary allowance, and divide any remainder equally or according to a fixed ratio. The following example assumes 5 percent (.05) interest on the original investment, salary allowances of $10,000 to each partner, and any remainder to be divided equally. The following shows the calculations made to determine the distribution.

Share to Share to Share to Saar Loretto Abdullah Total Total Amount to Be Divided $36,000 Allocated as Interest: Saar (5% $50,000) $ 2,500 Loretto (5% $30,000) $ 1,500 Abdullah (5% $40,000) $ 2,000 Total Interest Ð6,000 Balance $30,000 Salary Allowances 10,000 10,000 10,000 Ð30,000 Totals to Each $12,500 $11,500 $12,000 0

There is no remainder to be divided in this instance. The following is the journal entry to close the Income Summary to the capital accounts.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Income Summary 3600000 Saar, Capital 1250000 Loretto, Capital 1150000 Abdullah, Capital 1200000 To Record the Closing of the Income Summary to Capital

Now assume the same facts except that Saar will receive $10,000 salary allowance, Loretto will receive $8,000, and Abdullah will receive $9,000. The remainder, if any, will be divided equally. The calculation to determine the distribution would then be as follows:

Share to Share to Share to Saar Loretto Abdullah Total Total Amount to Be Divided $36,000 5% Interest $ 2,500 $ 1,500 $ 2,000 Ð6,000 Balance $30,000 Salary Allowance 10,000 8,000 9,000 Ð27,000 Balance 3,000 Remainder Divided by 3 1,000 1,000 1,000 Ð3,000 Totals $13,500 $10,500 $12,000 0 Partnership Accounting 383

The general journal entry to close the Income Summary to the capital accounts is as follows:

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Income Summary 3600000 Saar, Capital 1350000 Loretto, Capital 1050000 Abdullah, Capital 1200000 To Record the Closing of the Income Summary to Capital

The methods illustrated thus far are used for calculating the proper allocation of profits to the partners. The use of the salary allowance method does not require the partners to withdraw a certain amount as salary. The salary allowances are used solely for calculating the distribution of net income. The closing of the Income Summary account to the capital accounts of the partners is the end result of the method used to share profits or losses.

Partnership Financial Statements

The financial statements of a partnership business are similar to those of a proprietorship. The income statement, statement of changes in partners’ equity and the balance sheet follow. Assume that each partner has withdrawn $8,000 during the year. 384 CHAPTER fourteen

Saar, Loretto, and Abdullah, Accountants Income Statement For Year Ended December 31, 20XX Professional Revenue $9600000 Operating Expenses 6000000 Net Income $3600000

Allocation of Net Income to the Partners: Saar Interest at 5% (.05 $50,000) $ 250000 Salary Allowance 1000000 1/3 of Remaining Net Income 100000 Total $1350000

Loretto Interest at 5% (.05 $30,000) $ 150000 Salary Allowance 800000 1/3 of Remaining Net Income 100000 Total $1050000

Abdullah Interest at 5% (.05 $40,000) $ 200000 Salary Allowance 900000 1/3 of Remaining Net Income 100000 Total $1200000

Net Income Allowed $3600000

Saar, Loretto, and Abdullah, Accountants Statement of Changes in Partners’ Equity For Year Ended December 31, 20XX Saar Loretto Abdullah Total Capital, January 1 5000000 3000000 4000000 12000000 Add: Additional Invest. 0 00 0 00 0 00 0 00 Add: Net Income 1350000 1050000 1200000 3600000 Subtotals 6350000 4050000 5200000 15600000 Deduct: Withdrawals 8 0 0 0 00 8 0 0 0 00 8 0 0 0 00 2400000 Capital, December 31 5550000 3250000 4400000 13200000 Partnership Accounting 385

Saar, Loretto, and Abdullah, Accountants Balance Sheet December 31, 20XX Assets Cash $9200000 Other Assets 5000000 Total Assets $14200000

Liabilities Accounts Payable $1000000

Owners’ Equity Saar, Capital $5550000 Loretto, Capital 3250000 Abdullah, Capital 4400000 13200000 Total Liabilities and Owner’s Equity $14200000

Accounting for a Deficit When Distributing Net Income In the event the method used for distribution of net income results in a deficit amount (negative) after interest and salary allowances, the deficit must be subtracted in the calculation rather than added. Assume for the partnership of Saar, Loretto, and Abdullah that the method for distributing net income or loss is to calculate interest at 5 percent of the original investment, give salary allowances of $10,000, $8,000, and $9,000, respectively, and divide any remainder equally. The following example will show the use of this method when profits are $24,000. The calculation to determine the distribution is as follows:

Share to Share to Share to Saar Loretto Abdullah Total Total Amount to Be Divided $24,000 5% Interest $ 2,500 $ 1,500 $ 2,000 Ð6,000 Balance $18,000 Salary Allowance 10,000 8,000 9,000 Ð27,000 Deficit Balance $(9,000) Deficit Distributed (3,000) (3,000) (3,000) 9,000 Totals $ 9,500 $ 6,500 $ 8,000 0

The general journal entry to close the Income Summary to the capital accounts will debit income summary for $24,000 and credit the individual capital accounts.

Distributing a Net Loss The above examples cover only net income. Should a loss occur, the procedure for distributing the loss to the partners’ capital accounts is the same as distributing net income unless the partners agree otherwise. Losses will reduce both assets and capital. Assuming that the partners share profits and losses equally, and assuming a $36,000 loss, the closing entry debits the individual partner’s capital accounts $12,000 each and credits Income Summary for $36,000. 386 CHAPTER fourteen

The Account Form Balance Sheet An account form balance sheet shows the assets on the left-hand side and liabilities and owner’s equity on the right-hand side. The account form balance sheet will be used in this chapter to demonstrate changes in the balance sheet as they occur from the withdrawal of a partner, the addition of a partner, or a partnership going out of business. The report form balance sheet has been used in previous chapters. Following are illustrations of various possibilities for changes in the composition of the partnership.

Withdrawing or Adding a New Partner A partnership is based on a contractual agreement among individuals and ends when a partner withdraws from the firm or a new partner is added. The business, however, may continue with a new partnership agreement. A partner may withdraw by selling his or her interest or equity in cash or other assets. If all the partners agree, a new partner may join the firm either by buying the interest of a present partner, by contributing additional assets equal to the equity he or she is acquiring, or by investing either more or less than the equity he or she will receive. The partnership agreement should outline the procedure governing a partner who wishes to withdraw from the business. Withdrawal may occur when a partner wants to retire or does not wish to continue under the present business arrangements. For example, assume that Abdullah, with an equity of $40,000, wants to retire. The partnership contract provides that an audit be performed which includes having all assets appraised to determine market value. In addition, a determination must be made of all liabilities of the partnership. Should the audit reveal that assets and liabilities are different than reflected on the books of the partnership, adjustments are made to the record to determine the true equities of the partners. Once this is accomplished, the contract may pro- vide that assets be distributed to the retiring partner if it does not jeopardize the future profitability of the remaining partners.

Sale of Partnership Interest for More Than Partner’s Equity Assume that M. Saar wants to sell his interest to B. Knight. The balance sheet before this sale is as follows:

Saar, Loretto, and Abdullah, Accountants Balance Sheet December 31, 20XX Assets Liabilities and Owners’ Equity Liabilities Cash $ 5000000 Accounts Payable $ 1000000 Other Assets 8000000 Owners’ Equity Saar, Capital $5000000 Loretto, Capital 3000000 Abdullah, Capital 4000000 12000000 Total Liabilities and Total Assets $13000000 Owner’s Equity $13000000 Partnership Accounting 387

Knight has agreed to pay Saar $60,000 for his equity in the business. Loretto and Abdullah agree to accept Knight as a partner. The general journal entry to record the transfer is as follows:

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Aug. 31 Saar, Capital 5000000 Knight, Capital 5000000 To Record the Transfer of Saar’s Equity in the Partnership to Knight

After this entry, the old partnership is ended and a new partnership is formed. The only change in the balance sheet will be the substitution of Knight for Saar. After the new partnership is formed, a new contract is written. Two points should be noted. First, the $60,000 Knight paid Saar was a personal transaction between the two and does not affect the partnership records. The $50,000 equity of Saar is transferred to Knight with the approval of the other two partners. Remember, the business entity concept requires that personal transactions be kept separate from business transactions. The second point to note is that Loretto and Abdullah must agree to have Knight as a partner since a partnership is based on agreement of all parties.

Partner Admitted with Investment Same as Equity Assume that Knight is to invest $40,000 in cash to receive a one-fourth interest in the partnership. The following shows the equity of the present owners: Saar $ 50,000 Loretto 30,000 Abdullah 40,000 Total $120,000 After Knight’s investment of $40,000, the total equity is $160,000. One-fourth of $160,000 is $40,000, the equity of the new partner. The journal entry to illustrate the addition of Knight under this assumption is as follows:

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Aug. 31 Cash 4000000 Knight, Capital 4000000 To Record the Addition of Knight as a Partner with a One-Fourth Interest 388 CHAPTER fourteen

After the entry is posted, the assets and equities of the new partnership will appear as follows:

Saar, Loretto, and Abdullah, Accountants Balance Sheet December 31, 20XX Assets Liabilities and Owners’ Equity Liabilities Cash $ 9000000 Accounts Payable $ 1000000 Other Assets 8000000 Owners’ Equity Saar, Capital $5000000 Loretto, Capital 3000000 Abdullah, Capital 4000000 Knight, Capital 4000000 16000000 Total Liabilities and Total Assets $17000000 Owner’s Equity $17000000

Withdrawal of a Partner Assume that Abdullah wants to retire and will accept cash equal to her equity. Assume further that assets and liabilities are the same as presented on the balance sheet on page 386 and that the withdrawal of cash by Abdullah will not jeopardize the firm’s cash posi- tion. The general journal entry to record the withdrawal of Abdullah is as follows.

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Aug. 31 Abdullah, Capital 4000000 Cash 4000000 To Record the Withdrawal of Rose who Receives Cash Equal to Her Equity

Sometimes when a partner retires, the remaining partners may not wish to give an amount equal to the retiring partner’s equity. The retiring partner may then agree to take an amount less than the value of his or her capital account. If this is the situation, the profit-loss sharing ratio is used to adjust the capital accounts of the remaining partners. Assume that the profits and losses are to be divided equally, and Abdullah agrees to take $30,000 in cash for her $40,000 equity. The entry to show the withdrawal of Abdullah for $30,000 cash is as follows: Partnership Accounting 389

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Aug. 31 Abdullah, Capital 4000000 Cash 3000000 Saar, Capital 500000 Loretto, Capital 500000 To Record the Withdrawal of Abdullah who Receives Cash Less Than Her Equity

Bonus to Old Partners A new partner may be expected to invest more assets than the equity he or she is to receive. This might occur because the equities of the present partners may not reflect the true worth of an already successful business. If this is the case, the partnership is worth more than the records indicate. For example, assume that the present equities are the same as previously indicated and that Knight is to invest cash of $36,000 for a one-fifth interest. The amount to be credited to Knight’s capital account for a 1/5 interest is determined as follows:

Equities of the present partners $120,000 Investment of the new partner 36,000 Total equities of the new partnership 156,000 Equity of Knight (1/5 $156,000 = $31,200) $ 31,200

Providing the present partners share equally, the bonus of $4,800 (the difference between the cash given, $36,000, and the equity received, $31,200) will be divided by 3 and the capital accounts of the present partners will each be increased by $1,600. The following is the journal entry to admit Knight as one-fifth partner.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Aug. 31 Cash 3600000 Saar, Capital 160000 Loretto, Capital 160000 Abdullah, Capital 160000 Knight, Capital 3120000 To Record the Addition of Knight as Partner with a One-Fifth Interest 390 CHAPTER fourteen

After the entry is posted, the assets, liabilities, and owners’ equity are as follows:

Saar, Loretto, and Abdullah, Accountants Balance Sheet December 31, 20XX Assets Liabilities and Owners’ Equity Liabilities Cash $ 8600000 Accounts Payable $ 1000000 Other Assets 8000000 Owners’ Equity Saar, Capital $5160000 Loretto, Capital 3160000 Abdullah, Capital 4160000 Knight, Capital 3120000 15600000 Total Liabilities and Total Assets $16600000 Owner’s Equity $16600000

Bonus to New Partner A bonus may be given to a new partner when the new partner is given more equity than his or her current capital balance. Assume that Knight invests $20,000 for a one-fourth interest. The equity given to Knight in this case is greater than his equity. Thus Saar, Loretto, and Abdullah, who share net income and losses equally, must give up an equal- portion of their equity to Knight as determined below.

Equities of the present partners $120,000 Add investment of new partner 20,000 Total equities of the new partnership 140,000 Equity of Knight (1/4 $140,000 = $35,000) $ 35,000

There is $15,000 difference between the $20,000 cash investment of Knight and total equity of $35,000 he received. The $15,000 is a bonus to Knight. However, the difference must be shared by the present partners as a reduction in their capital accounts. The reduction in the capital accounts is $5,000 each. The entry to record the addition of Knight under these circumstances is as follows.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Aug. 31 Cash 2000000 Saar, Capital 500000 Loretto, Capital 500000 Abdullah, Capital 500000 Knight, Capital 3500000 To Record the Addition of Knight as a Partner with a One-Fourth Interest Partnership Accounting 391

After the entry is posted, the assets, liabilities, and owners’ equity appear as follows.

Saar, Loretto, and Abdullah, Accountants Balance Sheet December 31, 20XX Assets Liabilities and Owners’ Equity Liabilities Cash $ 7000000 Accounts Payable $ 1000000 Other Assets 8000000 Owners’ Equity Saar, Capital $4500000 Loretto, Capital 2500000 Abdullah, Capital 3500000 Knight, Capital 3500000 14000000 Total Liabilities and Total Assets $15000000 Owner’s Equity $15000000

This type of situation might occur when a new partner has a special talent or business skill that will increase the profitability of the firm. However, there are times when a bonus is not recorded at all. Rather, goodwill is recorded and the old partners’ capital accounts are increased. This method is seldom used; the bonus method is the preferred method. In the event the two remaining partners are eager to see Abdullah retire, they may abe willing to give more than Abdullah’s equity. Assume that they agree to give Abdullah $40,000 in cash and a note payable for $10,000 for her $40,000 equity. The entry to record this situation is as follows:

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Aug. 31 Abdullah, Capital 4000000 Saar, Capital 500000 Loretto, Capital 500000 Cash 4000000 Notes Payable 1000000 To Record the Withdrawal of Abdullah Who Receives Cash and a Note Payable for Her Equity

The remaining partners share the additional equity given to Abdullah as a loss to them- selves. Many other variations similar to these can be used. However, whatever method is used, assets must equal liabilities and owners’ equity at all times. 392 CHAPTER fourteen

Going Out of Business—Liquidation

Partners may determine that it is no longer possible to continue in business. This may occur if the partners have unsettled disputes or the business is no longer profitable and liquidation becomes necessary. Liquidation is the total process of going out of business, or the legal process of converting assets to cash, paying all creditors, and making final distribution of cash to the partners. This legal process also means that each partner is liable to pay the creditors whether or not there is sufficient cash remaining. Although many different circumstances occur in liquidation, only two are discussed here. In each case, there are four steps to be followed. 1. Convert all noncash assets to cash and record the gain or loss on liquidation. 2. Distribute the gains or losses to the partners’ capital accounts according to the profit-loss ratio. 3. Pay the liabilities. 4. Distribute the remaining cash according to the equities (capital balances) of the partners. A temporary account called Loss or Gain from Liquidation is opened to assemble the gains or losses that may occur when selling the assets. It is credited for a gain and debited for a loss. The conversion of noncash assets to cash is called realization. Partners will normally share losses and gains from liquidation using their income and loss sharing ratio.

Assets Sold for a Gain The liquidation of a partnership may be illustrated using the following information. Saar, Loretto, and Abdullah, the partners in the accounting firm in previous illustrations, have had a bitter dispute over business policies. They decide to dissolve the partnership. To illustrate a liquidation where assets are sold for a gain, assume the following balance sheet before liquidation.

Saar, Loretto, and Abdullah, Accountants Balance Sheet December 31, 20XX Assets Liabilities and Owners’ Equity Liabilities Cash $ 3000000 Accounts Payable $ 1000000 Other Assets 10000000 Owners’ Equity Saar, Capital $5000000 Loretto, Capital 3000000 Abdullah, Capital 4000000 12000000 Total Liabilities and Total Assets $13000000 Owner’s Equity $13000000

Assume that the other assets are sold for $109,000 and the partners share profits and losses equally. The four steps necessary upon liquidation are shown as journal entries. Partnership Accounting 393

1. Convert all noncash assets to cash and record the gain or loss on liquidation.

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Cash 10900000 Other Assets 10000000 Loss or Gain on Realization 900000 To Record the Sale of Other Assets

2. Distribute gains or losses to the partners’ capital accounts according to the profit- loss ratio.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Loss or Gain on Realization 900000 Saar, Capital 300000 Loretto, Capital 300000 Abdullah, Capital 300000 To Record the Closing of the Loss or Gain on Realization Account to the Partners’ Capital Accounts

After posting these two entries, the balance sheet appears as follows.

Saar, Loretto, and Abdullah, Accountants Balance Sheet December 31, 20XX Assets Liabilities and Owners’ Equity Liabilities Cash $13900000 Accounts Payable $ 1000000

Owners’ Equity Saar, Capital $5300000 Loretto, Capital 3300000 Abdullah, Capital 4300000 12900000 Total Liabilities and Total Assets $13900000 Owner’s Equity $13900000 394 CHAPTER fourteen

3. Pay the liabilities.

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Accounts Payable 1000000 Cash 1000000 To Record Payment to the Creditors

4. Distribute the remaining cash according to the equities of the partners.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Saar, Capital 5300000 Loretto, Capital 3300000 Abdullah, Capital 4300000 Cash 12900000 To Record the Closing of the Partnership Books

Once the above entries are posted, every account in the partnership records will have a zero balance, signifying the termination of this business. It is important to remember that cash remaining after liquidation is distributed to partners according to their capital balances while gains and losses from liquidation are allocated according to the income and loss sharing ratio. Assets Sold for a Loss Many times a business cannot sell its other assets at the amount carried in the records. Assets will deteriorate with age and therefore are not as marketable as when they were new. Assume that other assets are listed on the balance sheet at $100,000 and that they are sold for $91,000. This is a $9,000 loss to the partners and will result in reducing both their assets and capital accounts. Each of the four steps are presented as journal entries as follows. 1. Convert all noncash assets to cash and record the gain or loss on liquidation.

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Cash 9100000 Loss or Gain on Realization 900000 Other Assets 10000000 To Record the Sale of Other Assets Partnership Accounting 395

2. Distribute the gains or losses to the partners’ capital accounts according to the profit-loss ratio.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Saar, Capital 300000 Loretto, Capital 300000 Abdullah, Capital 300000 Loss or Gain on Realization 900000 To Record the Closing of the Loss to Partners’ Capital Accounts

3. Pay the liabilities.

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Accounts Payable 1000000 Cash 1000000 To Record the Payment of the Creditors

After the above entries are posted, the T-accounts will appear as follows:

Cash Other Assets Accounts Payable 30,000 10,000 100,000 100,000 10,000 10,000 91,000 111,000

Saar, Capital Loretto, Capital Abdullah, Capital 3,000 50,000 3,000 30,000 3,000 40,000 47,000 27,000 37,000

Loss or Gain on Realization 9,000 9,000

There is $111,000 left in the Cash account, and the total remaining capital account balances equal $111,000. In step four, the amount of cash to be distributed to each partner is determined by the balance in each partner’s capital account.

4. Distribute the remaining cash according to the equities of the partners. 396 CHAPTER fourteen

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Saar, Capital 4700000 Loretto, Capital 2700000 Abdullah, Capital 3700000 Cash 11100000 To Record the Closing of the Partnership Books

After this entry is posted, all the accounts have a zero balance and the partnership is terminated. A problem may occur if one partner’s share of the loss is greater than the balance of his or her capital account. If this is the case, the partner must cover the deficit by paying cash into the partnership. In this situation, a deficit is a debit balance in a partner’s capital account. This could occur from liquidation losses, losses from previous periods, or withdrawals before liquidation. For example, assume the partners Saar, Loretto, and Abdullah share profits and losses in a 2:2:1 ratio. If the other assets are shown at $100,000 on the balance sheet and sold for $20,000, a loss of $80,000 must be distributed. The four steps, presented as journal entries, will illustrate this problem and are as follows. 1. Convert all assets to cash.

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Cash 2000000 Loss or Gain on Realization 8000000 Other Assets 10000000 To Record the Sale of the Other Assets

2. Distribute the gains or losses to the partners’ capital accounts according to the profit-loss ratio. Partnership Accounting 397

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Saar, Capital * 3200000 Loretto, Capital 3200000 Abdullah, Capital 1600000 Loss or Gain on Realization 8000000 To Record the Closing of the Loss to the Partners’ Capital Accounts on a 2:2:1 Ratio

*Calculation of division of loss: Saar 2/5 $80,000 = $32,000 Bagwell 2/5 $80,000 = 32,000 Abdullah 1/5 $80,000 = 16,000

3. Pay the creditors.

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Accounts Payable 1000000 Cash 1000000 To Record the Payment of the Creditors

After the above entries are posted, the T accounts will appear as follows:

Cash Other Assets Accounts Payable 30,000 10,000 100,000 100,000 10,000 10,000 20,000 40,000

Saar, Capital Loretto, Capital Abdullah, Capital 32,000 50,000 32,000 30,000 16,000 40,000 18,000 2,000 24,000

Loss or Gain on Realization 80,000 80,000

Loretto has a debit balance of $2,000 in his capital account and is liable to the partnership for his deficit. If Loretto has sufficient personal assets and contributes $2,000 to the firm to cover his debit balance, step four can be completed as follows: 4. Distribute the remaining cash according to the equities of the partners. a. Payment of cash by Loretto. 398 CHAPTER fourteen

GENERAL JOURNAL PAGE POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Cash 200000 Loretto, Capital 200000 To Record the Cash Contribution of Loretto to Cover His Liability

b. Distribute remaining cash.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Saar, Capital 1800000 Abdullah, Capital 2400000 Cash 4200000 To Record the Closing of the Partnership Books

After posting these two entries, all the accounts have a zero balance and the partnership is terminated. However, if Loretto has no personal assets and cannot pay his debt, because of unlimited liability Saar and Abdullah must share this additional loss according to their portion of the profit-loss ratio, without Loretto, which is 2:1. The journal entries for step four under these circumstances are as follows. 4. Distribute the remaining cash according to the equities of the partners. a. Distribute the $2,000 loss.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Saar, Capital * 133300 Abdullah, Capital 6 6 7 00 Loretto, Capital 200000 To Record Loretto’s Liability as a Loss to the Remaining Partners

*Calculation of division of loss: Saar 2/3 $2,000 = $1,333 Abdullah 1/3 $2,000 = 667 Partnership Accounting 399

b. Distribute the remaining cash.

GENERAL JOURNAL Page POST DATE DESCRIPTION REF. DEBIT CREDIT 20XX Dec. 31 Saar, Capital 1666700 Abdullah, Capital 2333300 Cash 4000000 To Record the Closing of the Partnership Books

After posting of the above entries, all the accounts have a zero balance and the partnership is terminated. Even though the partner with the deficit cannot pay at the present time, the liability is not eliminated. If the deficit partner becomes able to pay at some time in the future, he or she must do so.

Summary

A partnership is a voluntary association of two or more legally competent persons to carry on as co-owners a business for profit. It is best if they have a written partnership agreement, but their contract may be a verbal one. Partnerships are characterized by limited life, which means that the partnership cannot exist separate from the individual partners, thus it may end when one partner becomes unable, through death, bankruptcy or lack of legal capacity, to contract. Partners, through mutual agency, have the legal ability to enter into contracts within the scope of the partnership. Such contracts are binding on the other partners. Unlimited liability, which also characterizes partnerships, refers to the fact that each partner is personally liable for the debts of the business. Though there are many advantages to forming a partnership, limited life, unlimited liability, and mutual agency are disadvantages that should be considered before forming a new partnership. Partnership accounting is the same as proprietorship accounting, except that each partner has his or her own drawing account. Partners are owners of the business and do not receive salaries; rather, their drawing accounts are debited when cash is taken for personal use and income taxes are based on their share of the net income of the business. Partners will decide upon a profit-loss ratio which will be used to determine how profits and losses are to be allocated. Profits and losses may be distributed: (1) equally; (2) on a fractional basis; (3) based on amounts invested; or (4) using a fixed ratio. Should there be a loss, it will be distributed to the partners’ capital accounts the same way as a net income unless there is an agreement to the contrary. A new partnership may be created when a new individual buys the interest of one of the existing partners, or if an additional person is admitted as a partner. In such a case, the old partnership is dissolved. In addition to adding a new partner, an existing partner may wish to withdraw from the partnership. In such a case, the value of all assets and liabilities of the partnership must be determined by an audit. 400 CHAPTER fourteen

Partners may decide, because, for example, of unsettled disputes or lack of profitability, to liquidate. When this occurs: (1) all noncash assets must be converted to cash (called realization) and the gain or loss on liquidation recorded; (2) gains or losses must be distributed to the partners’ capital accounts according to their profit-loss ratio; (3) liabilities must be paid; and (4) any remaining cash must be distributed to the partners according to their capital balances. Partners normally share gains and losses from liquidation according to their profit-loss sharing ratio.

Vocabulary Review

Here is a list of the words and terms for this chapter: account form balance sheet partnership deficit profit-loss ratio liquidation realization mutual agency unlimited liability

Fill in the blank with the correct word or term from the list. 1. The total process of going out of business is ______. 2. A/an ______is an association of two or more competent persons who agree to do business as co-owners for profit. 3. The ability of each partner, acting as an agent of the business, to enter into and bind it to contracts within the apparent scope of the business is ______. 4. ______is the conversion of noncash assets to cash. 5. The method used by the partners to divide profits or losses in the ______. 6. A/an ______is an abnormal balance in a capital account. 7. The principle that each partner is personally liable for the debts of the business is called ______. 8. ______shows the three major categories—assets, liabilities, and owner’s equity—in a horizontal manner. Partnership Accounting 401

Match the words and terms on the left with the definitions on the right. 9. account form balance sheet a. the method used by the partners to divide 10. deficit profits or losses 11. liquidation b. each partner is personally liable for the debts of the business 12. mutual agency c. an association of two or more competent 13. partnership persons who agree to do business as 14. profit-loss ratio co-owners for profit 15. realization d. an abnormal balance in a capital account 16. unlimited liability e. the conversion of noncash assets to cash f. the total proces of going out of business g. the ability of each partner, acting as an agent of the business, to enter into and bind it to contracts within the apparent scope of the partnership h. the format of a balance sheet that shows the assets, liabilities, and owners’ equity in a horizontal manner Exercises EXERCISE 14.1 Morton and Long plan to enter into a law partnership, investing $30,000 and $20,000, respectively. They have agreed on everything but how to divide the profits. Calculate each partner’s share of the profit under each of the following independent assumptions. a. If the first year’s net income is $50,000 and they cannot agree, how should the profits be divided? b. If the partners agree to share net income according to their investment ratio, how should the $50,000 be divided? c. If the owners agree to share net income by granting 10 percent interest on their original investments, giving salary allowances of $10,000 each, and dividing the remainder equally, how should the $50,000 be divided?

EXERCISE 14.2 Assume Morton and Long from Exercise 14.1 use method c to divide profits and net income is $20,000. How should the income be divided?

EXERCISE 14.3 After a number of years, Long, from Exercise 14.1, decided to go with a large law firm and wishes to sell his interest to Brown. Long’s equity at this time is $35,000. Morton agrees to take Brown as a partner, and Long sells his interest to Brown for $40,000. Prepare the general journal entry on December 31, 20XX to record the sale of Long’s interest to Brown. 402 CHAPTER fourteen

EXERCISE 14.4 Smith, White, and Saint are partners owning the Book Nook. The equities of the partners are $60,000, $50,000, and $40,000, respectively. They share profits and losses equally. White wishes to retire on May 31, 20XX. Prepare the general journal entries to record White’s retirement under each independent assumption. a. White is paid $50,000 in partnership cash. b. White is paid $40,000 in partnership cash. c. White is paid $55,000 in partnership cash.

EXERCISE 14.5 Hall and Mason share profits and losses equally and have capital balances of $60,000 and $40,000, respectively. Taylor is to be admitted on January 2, 20XX, and is to receive a one-third interest in the firm. Prepare the general journal entries to record the addition of Taylor as a partner under the following unrelated circumstances. a. Taylor invests $50,000. b. Taylor invests $62,000. c. Taylor invests $47,000.

EXERCISE 14.6 Martin, Pearson, and Henderson are partners sharing profits and losses in a 2:1:1 ratio. Their capital balances are $30,000, $25,000, and $20,000, respectively. Because of an eco- nomic turndown, they have decided to liquidate. After all assets are sold and the creditors paid, $43,000 cash remains in the business chequing account. a. Determine the amount of their losses by using the accounting equation. b. Using the profit-loss ratio, determine the amount of loss to be distributed to each partner, and determine their new capital balances. c. Determine the amount of cash each partner will receive in the final distribution.

EXERCISE 14.7 Baker, Marshall, and Perryman share profits and losses equally and begin their business with investments of $20,000, $15,000, and $8,000, respectively. They have been unprof- itable in their business venture and decide they must liquidate. After all the assets are sold and all debts paid, $16,000 cash remains in the business chequing account. a. Determine the amount of their losses by using the accounting equation. b. Using the profit-loss ratio, determine the amount of loss allocated to each partner, and determine their new capital balances. c. Calculate the amount of cash, if any, each partner will receive under the different assumptions below. (1) Perryman has personal assets and pays the amount she owes to the partnership. (2) Perryman has no personal assets and does not pay the amount she owes to the partnership. Partnership Accounting 403

Problems PROBLEM 14.1 Jones, Brady, and Bell formed a partnership making investments of $40,000, $60,000, and $80,000, respectively. They believe the net income from their business for the first year will be $81,000. They are considering several alternative methods for sharing this expected profit, which are: (1) divide the profits equally; (2) divide the profits according to their investment ratio; (3) divide the profits by giving an interest allowance of 10 percent on original investments, granting $10,000 salary allowance to each partner, and dividing any remainder equally. Round to the nearest dollar where required.

Instructions a. Prepare a schedule showing distribution of net income under methods 1, 2, and 3. It should have the following headings.

Share to Share to Share to Total Plan Calculations Jones Brady Bell Allocated

b. Using method 3 above, prepare a partial income statement showing the allocation of net income to the partners (see income statement on page 384 for example). c. Journalize the closing of the Income Summary account on December 31, 20XX using the information from b above.

PROBLEM 14.2 Abner, Black, and Cobb share profits and losses equally and have capital balances of $60,000, $50,000, and $50,000, respectively. Cobb wishes to sell his interest and leave the business on July 31 of this year. Cobb is to sell his interest to Williams with the approval of Abner and Black. Instructions Prepare the general journal entries, without explanations, to record the following independent assumptions. a. Cobb sells his interest to Williams for $50,000. b. Cobb sells his interest to Williams for $40,000. c. Cobb decides to stay in the partnership but sell one-half of his interest to Williams for $30,000. (Hint: What is the value of half of Cobb’s capital account?) d. If Williams is admitted as a new partner, must a new partnership agreement be written? Why? PROBLEM 14.3 Coleman and Simmons are partners and own the ABC Gift Shop. They formed their partnership on January 2, 20XX, with investments of $50,000 and $25,000. Simmons invested an additional $5,000 on July 7. They share profits giving 10 percent interest allowance on beginning investments and dividing the remainder on a 2:1 ratio. Following is their trial balance before closing. 404 CHAPTER fourteen

Coleman and Simmons Trial Balance December 31, 20XX Cash $ 1900000 Accounts Receivable 500000 Merchandise Inventory 6000000 Equipment 2000000 Accumulated Amortization: Equipment $ 1000000 Accounts Payable 1000000 Coleman, Drawing 1000000 Simmons, Drawing 1000000 Coleman, Capital 5000000 Simmons, Capital 3000000 Sales 10000000 Operating Expenses 7600000 $20000000 $20000000

a. Prepare the general journal entries, without explanations, to record the closing of all the nominal accounts (revenue and expense) using the Income Summary account. b. Prepare a schedule showing the distribution of net income to the partners. It should have the following headings.

Share to Share to Total Calculations Coleman Simmons Allocated

c. Prepare the general journal entries to record the closing of the Income Summary account to the capital accounts, and close the drawing accounts to the capital accounts. d. Prepare the partnership income statement showing the allocation of net income. e. Prepare the statement of owners’ equity. f. Prepare a balance sheet.

PROBLEM 14.4 Arnold, Cole, and Yamaguchi are partners, owning Pizza Plus and sharing profits and losses in a 3:2:1 ratio. The balance sheet, presented in account form format for this business, is as follows. Partnership Accounting 405

Arnold, Cole, and Yamaguchi Balance Sheet June 30, 20XX Assets Liabilities and Owners’ Equity Cash $ 6500000 Liabilities Delivery Truck #1 2500000 Accounts Payable $ 300000 Acc. Amort. Tr. #1 1000000 1500000 Delivery Truck #2 3500000 Owners’ Equity Acc. Amort. Tr. #2 700000 2800000 Arnold, Capital 6000000 Cole, Capital 3000000 Yamaguchi, Capital 1500000 10500000

Total Liabilities and Total Assets $10800000 Owner’s Equity $10800000

Arnold wishes to withdraw from the firm. Cole and Yamaguchi agree. Prepare the general journal entries, without explanations, to record the June 30 withdrawal of Arnold under the following independent assumptions. a. Arnold withdraws taking partnership cash of $60,000. b. Arnold withdraws taking cash of $32,000 and truck #2 (debit Accumulated Amortization and credit Truck). c. Arnold withdraws taking cash of $51,000 d. Arnold withdraws taking cash of $25,000 and a $44,000 note given by the partnership. e. Arnold withdraws taking cash of $25,000, a $20,000 note, and truck #1.

PROBLEM 14.5 Garcia, Keller, and Henley are partners who share profits and losses in a 3:1:2 ratio. Their capital account balances are $60,000, $25,000, and $35,000, respectively. Watts is to be admitted to the firm on March 31, 20XX with a one-fourth interest. Instructions Prepare the general journal entries to record the following unrelated assumptions. Omit explanations. a. Watts is to be admitted by investing cash of $40,000. b. Watts is to be admitted by investing cash of $30,000. c. Watts is to be admitted by investing cash of $50,000.

PROBLEM 14.6 Bentley, Colby, and Musharaf plan to liquidate their partnership. They share profits and losses on a 3:2:1 ratio. At the time of liquidation, the partnership balance sheet appears as follows: 406 CHAPTER fourteen

Bentley, Colby, and Musharaf Balance Sheet June 30, 20XX Assets Liabilities and Owners’ Equity Liabilities Cash $ 2300000 Accounts Payable $ 3000000 Other Assets 11500000 Owners’ Equity Bentley, Capital 4800000 Colby, Capital 3600000 Musharaf, Capital 2400000 10800000 Total Liabilities and Total Assets $13800000 Owner’s Equity $13800000

Prepare the general journal entries, without explanations, to record (1) the sale of the other assets; (2) the distribution of the loss or gain on realization; (3) the payment to the creditors; and (4) the final distribution of cash. Each of the following are unrelated assumptions. a. The other assets are sold for $115,000. b. The other assets are sold for $79,000. c. The other assets are sold for $55,000.

PROBLEM 14.7 Irby, Jalisco, and Whitehorse are partners in a video rental business, sharing profits and losses in a 2:1:1 ratio. Business has decreased due to the number of other rental stores in their area. They decide it would be best to liquidate. Their December 31, 20XX balance sheet information is as follows.

Balance Sheet Information Cash $15,000 Video Inventory 75,000 Accounts Payable 25,000 Irby, Capital 25,000 Jalisco, Capital 20,000 Whitehorse, Capital 20,000

Instructions Prepare the general journal entries, without explanations, to show: (1) the sale of the noncash assets; (2) the distribution of the losses or gains; (3) the payment to the creditors; and (4) the final distribution of cash under each of the following independent assumptions. a. The video inventory is sold for $63,000. b. The video inventory is sold for $25,000 c. The video inventory is sold for $20,000 and the partner with the deficit can and does pay from personal assets. d. The same assumption as c above, except the partner with the deficit cannot pay.