APPENDIX B Partnerships Partnerships and Related Forms of Business

Appendix B 11/20/06 10:38 AM Page B-2

APPENDIX

Partnerships

B artnerships differ in many ways from sole proprietorships and corpo- Prations. Here, we describe their characteristics and those of related forms of business. We also examine management and accounting issues pertaining to the formation, dissolution, and liquidation of partnerships, as well as the division of income among partners. Because of the special characteristics of partnerships, individuals who engage in them should choose as partners people who have high ethical standards.

LEARNING OBJECTIVES

LO1 Describe the characteristics of partnerships and related forms of business. LO2 Record partners’investments of cash and other assets when a partnership is formed. LO3 Use stated ratios, capital balance ratios, and partners’salaries and interest to compute the income or losses that partners share. LO4 Record a person’s admission to or withdrawal from a partnership. LO5 Compute and record the distribution of assets to partners when they liquidate their partnership.

B-2 Appendix B 11/9/06 4:30 PM Page B-3

DECISION POINT A USER’S FOCUS ERNST & YOUNG

● How does a firm as large as Ernst & Young organize to accomplish its objectives?

● How does a partnership account for its partners’ interests?

● What happens when partners enter or withdraw from a partnership?

Many people think of partnerships as relatively small businesses, and usually they are right. However, some partnerships—among them law firms, investment companies, real estate companies, and accounting firms—are very large. One example is Ernst & Young, an organization with offices in 140 countries and revenues of almost $17 billion. Ernst & Young provides a wide range of services, including accounting and auditing services, tax reporting and operations, business risk services, and technology and security risk services. With over 2,000 partners and 108,000 employees (23,000 in the United States), it is one of the largest partnerships in the world.1 Appendix B 11/9/06 4:30 PM Page B-4

B-4 | APPENDIX B Partnerships Partnerships and Related Forms of Business

LO1 Describe the characteristics of partnerships and related forms of business.

he Uniform Partnership Act, which most states have adopted, defines a partnership as “an association of two or more persons to carry on as co- Towners of a business for profit.” Partnerships are treated as separate enti- Partnerships and sole ties in accounting, but legally there is no economic separation between them proprietorships are not legal and their owners. Here, we describe their characteristics and the management entities; corporations are. All three, issues involved in forming and operating them. We also describe variations on however, are considered accounting entities. the partnership form of business.

Characteristics of Partnerships A partnership is easy to form; two or more persons simply agree to be partners in a business venture. Because a partnership is a voluntary association rather than a legal entity, a partner is responsible under the law not only for the debts of the business, but also for the actions of other partners within the scope of the business. However, a partner can choose the people who join the partnership and in doing so should select persons who share his or her business objectives and ethical standards. Partnerships have several advantages: They are not only easy to form, but also easy to change; all that is required is agreement among the partners. They facilitate the pooling of capital resources and individual talents. They have no corporate tax burden. Because partnerships are not legal entities, they do not have to pay a federal income tax, as corporations do; however, they must file an informational return. There is no federal income tax on partnerships; partners are taxed at They allow the partners a certain amount of freedom and flexibility in oper- their personal rates. However, ating the business. The hierarchy and structures usually found in corpora- partnerships must file an tions are not a necessary characteristic of partnerships. informational return with the IRS, and some state and local Partnerships also have certain disadvantages: governments levy taxes on them. The life of a partnership is limited. One partner can bind the partnership to a contract (a characteristic called mutual agency). The partners have unlimited personal liability for the debts of the business. Partnerships have more difficulty than corporations in raising large amounts of capital, and transfer of ownership is also more difficult. To maximize the advantages of a partnership and minimize the disadvantages, the partners must have a carefully planned partnership agreement that covers various contingencies. Although this agreement does not have to be in writing, good business practice calls for a written document that clearly states the details of the arrangement. A partnership agreement should include the following: Name, location, and purpose of the business Names of the partners and their respective duties Investments of each partner Appendix B 11/9/06 4:30 PM Page B-5

Partnerships and Related Forms of Business | B-5

The advantages of partnerships are that they are easy to form and change, they facilitate the pooling of capital resources and talents, they pay no corporate taxes, and partners have a certain freedom and flexibility in operating the business. Because of these advantages, many people form partnerships with siblings or spouses. The husband and wife shown here are partners in a bakery enterprise.

Method of distributing income and losses Procedures for the admission and withdrawal of partners, withdrawal of assets allowed each partner, and the liquidation (termination) of the business Important considerations in drafting a partnership agreement are limited life, mutual agency, unlimited liability, co-ownership of property, participation in income or losses, and terms of dissolution and liquidation.

Limited Life Because a partnership is formed by an agreement between partners, it has a limited life . In contrast, a corporation, which is chartered by a state, has an unlimited life. A partnership is dissolved when a partner is admitted, withdraws, goes bankrupt, is incapacitated (to the point that he or she cannot perform as obligated), retires, or dies, or when the terms of the partnership agreement are met (e.g., when the project for which the partnership was formed is completed). The partnership agreement can be written in a way that allows the partnership to continue under any of these circumstances. For example, the agreement can state that if a partner dies, the remaining partner or partners must purchase the deceased partner’s capital at book value from the heirs.

Mutual Agency Each partner is an agent of the partnership within the scope of the business. Because of this mutual agency , any partner can bind the partnership to a business agreement as long as it is within the scope of the company’s normal operations. For example, partners in a used-car business can bind the partnership to a contract that involves the purchase or sale of used cars. But they cannot bind the partnership to a contract for buying chil- dren’s clothing or any other goods unrelated to the used-car business. Because of mutual agency, it is very important that the persons admitted to a partnership have integrity and share the business objectives of the other partners. For example, an unscrupulous partner could engage the partnership in a question- able business deal without the knowledge of the other partners.

Unlimited Liability Each partner has unlimited liability (i.e., personal responsibility) for all the debts of the partnership. If a partnership cannot pay Appendix B 11/9/06 4:30 PM Page B-6

B-6 | APPENDIX B Partnerships its debts, creditors must first satisfy their claims from the assets of the business. If those assets are not enough to pay all debts, the creditors can seek payment from the personal assets of each partner. If one partner’s personal assets are used up before the debts are paid, the creditors can claim the personal assets of the other partners. The only way a partner can avoid this liability is by declaring personal bankruptcy. (As discussed below, some states allow a partnership to be formed under a limited liability partnership law that pro- tects the personal assets of partners in most situations.)

Co-Ownership of Property When people invest property in a partnership, they give up the right to their separate use of the property. The property becomes an asset of the partnership and is owned jointly by the partners.

Participation in Income or Losses Each partner has the right to share in the firm’s income and the responsibility to share in its losses. The partnership agreement should state the method of distributing income and losses to each partner. If the agreement describes how income should be shared but does not mention losses, then losses are distributed in the same way as income. If the agreement does not describe the method of income and loss distribution, then the partners must by law share income and losses equally.

Dissolution and Liquidation The partnership agreement should consider the financial consequences of a partner’s entering or withdrawing from the firm, which will result in the dissolution or liquidation of the partnership. If the agreement does not specify how these issues are to be resolved, state laws will prevail, and the result may adversely affect one or more partners.

Special Types of Partnerships In the sections that follow, we discuss special types of partnerships that overcome some of the disadvantages of the basic form.

Limited Partnerships As we have noted, the potential loss of all partners in an ordinary partnership is limited only by personal bankruptcy laws. In a limited partnership (LP) , a general partner usually has unlimited liability, but the liability of the other partners is limited to the amount of their investments in the business, just as the investments of corporate stockholders are limited. Limited partnerships thus overcome a major disadvantage of an ordinary partnership.

FOCUS ON BUSINESS PRACTICE Why Are Limited Partnerships Used in Financing Big Projects? Limited partnerships resemble corporations in that the lia- and apartment complexes). For example, Alliance Capital bility of the partners is limited to the amount of their invest- Management Limited Partnership, a large investment ment in the business. Because limited partnerships curtail advisor, invests more than $90 billion in assets for corporate an investor’s risk, they are sometimes used in place of cor- and individual investors in many different companies and porations to raise funds from the public to finance large projects.Its partnership units,or shares of ownership,sell on projects, such as the exploration and drilling of oil and gas the New York Stock Exchange and can be purchased by the wells,the manufacture of airplanes,and the development of individual investor. In 2003, the units were selling at about real estate (including shopping centers, office buildings, $28 each and paid an annual dividend of $2.50 per share.2 Appendix B 11/9/06 4:31 PM Page B-7

Partnerships and Related Forms of Business | B-7

A joint venture is a partnership in which two or more entities collaborate to achieve a specific goal. AutoAlliance, a joint venture of Ford and Mazda, produces the Mazda 6 and the Ford Mustang at a 400-acre plant in Flat Rock, Michigan.This assembly- line worker is one of the plant’s more than 3,700 employees.

Limited Liability Partnerships Limited liability partnerships (LLPs) differ from limited partnerships in that they have no general partner and all partners’ personal assets are protected by law. In operation, however, they resemble ordinary partnerships. They are authorized by state laws and are used primarily by professional service organizations. Most big accounting firms, such as Ernst & Young, are organized as LLPs.

Joint Ventures A joint venture is a partnership in which two or more entities collaborate to achieve a specific goal, such as the manufacture of a product for a new market. Although joint ventures usually involve privately owned companies, they sometimes involve governments, especially in emerging economies. A joint venture brings together the resources, technical skills, political ties, and other assets of each party to achieve a common goal. The agreements involved in this type of partnership usually specify the duration of the agreement and how profits and losses are to be shared. Joint ventures have become increasingly common in today’s global business environment.

FOCUS ON BUSINESS PRACTICE Joint Ventures on the Internet The Internet has fostered cooperation among companies launched a joint venture that enables customers to make that are normally competitors. For example, eight metal online bookings at their hotels. Seven other hotel chains, manufacturers, including Allegheny Technologies Inc. including Marriott International, Hyatt,and Holiday and Alcoa Inc., have formed a joint venture in which they Inn, have formed a similar joint venture. In the automotive sell their products and provide services to customers industry, General Motors Corporation and other com- online. Hotel chains have also entered into joint ventures panies have a joint venture in which the purchase of parts that make use of the Internet. Accor, Europe’s largest hotel and supplies is coordinated over the Internet. chain; Hilton International;and Forte Hotels have Appendix B 11/9/06 4:31 PM Page B-8

B-8 | APPENDIX B Partnerships

FOCUS ON BUSINESS PRACTICE How Do Accounting Firms Encourage Ethical Conduct? Some well-publicized financial misstatements in recent Ernst & Young’s code provides a clear set of standards that years have raised serious questions about the integrity of establishes an ethical and behavioral framework for the financial reporting. Ernst & Young and other accounting challenging and difficult choices that persons in account- firms have set out to restore public confidence in the qual- ing firms often face.Fundamental to Ernst & Young’s code is ity of financial reporting by adopting a code of conduct. building relationships based on “doing the right thing.”3

Corporations That Resemble Partnerships Some types of corporations mimic the characteristics of partnerships. S corporations are corporations that U.S. tax laws treat as partnerships. Unlike normal corporations, S corporations do not pay federal income taxes. They have a limited number of stockholders, who report the income or losses on investments in the business on their personal tax returns. This avoids the problem of double taxation. Limited liability corporations (LLCs) are another type of corporation that resembles a partnership. In an LLC, the stockholders are partners, but their liability is limited to their investment in the company in a manner similar to stockholders in a business corporation. LLCs were established by law to pro- tect partners’ personal assets. They are used mainly by accounting and con- sulting firms and are similar in effect to limited liability partnerships.

Special-Purpose Entities Special-purpose entities (SPEs) are firms with limited lives that a company creates to achieve a specific objective. They may take the form of a partnership, joint venture, corporation, or trust. Finan- cial institutions have been using SPEs since the 1970s as a way of raising funds by bundling together receivables and other loans into packages that can be sold to investors or used to borrow funds. However, outside of financial institutions, SPEs were relatively unknown until 2001, when Enron’s unethical use of its SPEs was widely reported. Enron used its SPEs to transfer assets and any related debt off its balance sheet, conceal its losses and borrow money, and generally make its financial statements look far better than they actually were. By setting up the SPEs as partnerships and using the complex accounting rules for SPEs, Enron was able to avoid including these entities in its financial statements even though it kept a 97 percent ownership in them. The FASB has since clarified the accounting rules for SPEs, which it calls variable interest entities (VIEs).4

STOP• REVIEW• APPLY 1-1. What is a partnership, and what are its important characteristics? 1-2. What are the advantages of a partnership? What are its disadvantages? 1-3. What does unlimited liability mean when applied to a partnership? 1-4. If a partnership agreement does not address how the partners will share income or losses, how will income or losses be shared? 1-5. How does a limited partnership overcome a major disadvantage of ordinary partnerships, and how does it differ from a limited liability partnership? Appendix B 11/9/06 4:31 PM Page B-9

Accounting for Partners’Equity | B-9

1-6. What business form has become more prevalent in conducting global business? 1-7. What is an SPE? How was Enron’s use of SPEs unethical? Suggested answers to all Stop, Review, and Apply questions are available at http://college.hmco.com/accounting/needles/poa/10e/student_home.html.

Accounting for Partners’ Equity

LO2 Record partners’investments of cash and other assets when a partnership is formed.

lthough accounting for a partnership is very similar to accounting for a sole proprietorship, there are differences. One is that the owner’s equity Ain a partnership is called partners’ equity . In accounting for partners’ equity, it is necessary to maintain separate Capital and Withdrawals accounts for each partner and to divide the income and losses of the company among the partners. In the partners’ equity section of the balance sheet, the balance of each partner’s Capital account is listed separately: Liabilities and Partners’ Equity Total liabilities $28,000 Partners’ equity R. Jacobs, Capital $25,000 R. Beliniski, Capital 34,000 Total partners’ equity 59,000 Total liabilities and partners’ equity $87,000

Each partner invests cash, other assets, or both in the partnership according to the partnership agreement. Noncash assets should be valued at their fair market value on the date they are transferred to the partnership. The assets invested by a partner are debited to the proper asset account, and the total amount is credited to the partner’s Capital account. To show how partners’ investments are recorded, let’s assume that on July 1, 2008, Sara Hancock and Joe Rolla agree to combine their capital and equipment in a partnership to operate a jewelry store. In accordance with their partnership agreement, Hancock invests $28,000 in cash and $37,000 worth of furniture and displays, and Rolla invests $40,000 in cash and $30,000 worth of equipment. Rolla has a note payable on the equipment for $10,000, which the partnership assumes. The entries to record the partners’ initial investments are as follows:

2008 A L OE July 1 Cash 28,000 Furniture and Displays 37,000 S. Hancock, Capital 65,000 Initial investment of S. Hancock in Hancock and Rolla Appendix B 11/9/06 4:31 PM Page B-10

B-10 | APPENDIX B Partnerships

A L OE July 1 Cash 40,000 Equipment 30,000 Notes Payable 10,000 J. Rolla, Capital 60,000 Initial investment of J. Rolla in Hancock and Rolla

The partnership agreement specifies the values assigned to assets. These values can differ from those carried on the partners’ personal books. For exam- Rolla’s noncash contribution is equal to the fair market value of ple, the equipment that Joe Rolla contributes could have a value of only the equipment less the amount $22,000 on his books. The book value of Rolla’s equipment is not important. owed on the equipment. The fair market value of the equipment at the time of transfer is important, however, because it represents money that Rolla invests in the partnership.

STOP• REVIEW• APPLY 2-1. What value should be placed on the noncash assets that partners contribute to the partnership? 2-2. After a partnership is formed and a partner has transferred assets to the partnership, what is the value of the partner’s Capital account?

Distribution of Partnership Income and Losses

LO3 Use stated ratios, capital balance ratios, and partners’salaries and interest to compute the income or losses that partners share.

partnership’s income or losses can be distributed according to whatever method the partners specify in the partnership agreement. Income in partnerships normally has three components: The division of income is one area A in which a partnership differs from 1. Return to the partners for the use of their capital (called interest on partners’ a corporation. In corporations, capital) each common share receives an equal dividend. Partners can use 2. Compensation for services the partners have rendered (partners’ salaries) any method they agree on to 3. Other income for any special contributions individual partners may make divide partnership income. to the partnership or for risks they may take. The breakdown of total income into its three components helps clarify how much each partner has contributed to the firm. If all partners contribute equal capital, have similar talents, and spend the same amount of time in the business, then an equal distribution of income or losses would be fair. Because in most situations this is not the case, however, a means of accomplishing an equitable distribution is needed. If one partner works full time in the firm and another devotes only a fourth of his or her time, then the distribution of income or losses should reflect the difference. Distributing income or losses among partners can be accomplished by using stated ratios or capital balance ratios or by assigning an amount for partners’ salaries and interest based on the capital each contributed and sharing the remaining income according to stated ratios. Salaries and interest here are Appendix B 11/9/06 4:31 PM Page B-11

Distribution of Partnership Income and Losses | B-11 not salaries expense or interest expense in the ordinary sense of the terms. They do not affect the amount of reported net income. Instead, they refer to ways of determining each partner’s share of net income or net loss on the basis of time spent and money invested in the partnership.

Stated Ratios One method of distributing income or losses is to give each partner a stated ratio of the firm’s total income or loss. If each partner makes an equal contribution to the firm, the net income or net loss should be shared equally. It is important to understand that an equal contribution to the firm does not necessarily mean an equal capital investment in the firm. One partner may be devot- ing more time and talent to the firm, whereas another may have made a larger capital investment. When the partners’ contributions are unequal, unequal stated ratios are appropriate. Let’s assume that in its first year of operation, Hancock & Rolla Jewelers had a net income of $30,000. The partnership agreement states that the per- centages of income or losses to be distributed to Sara Hancock and Joe Rolla The computations of each are 60 percent and 40 percent, respectively. The computation of each partner’s partner’s share of net income are share of the income and the entry to show the distribution are as follows: relevant to the closing entries in which the Income Summary S. Hancock ($30,000 .60) $18,000 account is closed to the partners’ J. Rolla ($30,000 .40) 12,000 Capital accounts. Net income $30,000

2009 A L OE June 30 Income Summary 30,000 S. Hancock, Capital 18,000 J. Rolla, Capital 12,000 Distribution of income for the year to the partners’ Capital accounts

Capital Balance Ratios If invested capital produces the most income for the partnership, then income or losses may be distributed according to capital balances. In this case, the ratio may be based on each partner’s capital balance at the beginning of the fiscal year or on each partner’s average capital balance during the year. The partnership agreement must describe the method to be used.

Ratios Based on Beginning Capital Balances When the firm began its first fiscal year on July 1, 2008, Sara Hancock’s Capital account had a $65,000 balance, and Joe Rolla’s Capital account had a $60,000 balance. The total partners’ equity in the firm was then $125,000. Each partner’s capital balance at the beginning of the year, divided by the total partners’ equity at the beginning of the year, is that partner’s beginning capital balance ratio: Beginning Beginning Capital Capital Balance Balance Ratio S. Hancock $ 65,000 $65,000 $125,000 .52 52% J. Rolla60,000 $60,000 $125,000 .48 48% $125,000 Appendix B 11/9/06 4:31 PM Page B-12

B-12 | APPENDIX B Partnerships The income that each partner should receive when distribution is based on beginning capital balance ratios is determined by multiplying the net income by each partner’s capital ratio. If we assume that net income for the year was $140,000, Sara Hancock’s share of that income is $72,800, and Joe Rolla‘s is $67,200. S. Hancock $140,000 .52 $ 72,800 J. Rolla $140,000 .48 67,200 $140,000

Ratios Based on Average Capital Balances If Hancock and Rolla use beginning capital balance ratios to determine the distribution of income, they do not consider any investments or withdrawals made during the year. But investments and withdrawals usually change the partners’ capital ratios. If the partners believe their capital balances will change dramatically during the year, they can choose average capital balance ratios as a fairer means of distributing income or losses. The following T accounts show the activity over the year in the partners’ Capital and Withdrawals accounts:

S. HANCOCK, CAPITAL S. HANCOCK, WITHDRAWALS 7/1/08 65,000 1/1/09 10,000 J. ROLLA, CAPITAL J. ROLLA, WITHDRAWALS 7/1/08 60,000 11/1/08 10,000 2/1/09 8,000

Sara Hancock withdrew $10,000 on January 1, 2009. Joe Rolla withdrew $10,000 on November 1, 2008 and contributed an additional $8,000 of equipment on February 1, 2009. Again, the net income for the year’s operation (July 1, 2008, to June 30, 2009) was $140,000. The calculations for the average capital balances and the distribution of income are as follows:

Average Capital Balances Partner Date Capital Months Total Average Capital Balance Unchanged Balance Hancock July–Dec. $65,000 6 $390,000 Jan.–June $55,000 6 330,000 12 $720,000 12 $ 60,000 Rolla July–Oct. $60,000 4 $240,000 Nov.–Jan. $50,000 3 150,000 Feb.–June $58,000 5 290,000 12 $680,000 12 56,667 Total average capital $116,667

Average Capital Balance Ratios Hancock’s Average Capital Balance $60,000 Hancock .514 51.4% Total Average Capital $116,667 Rolla’s Average Capital Balance $56,667 Rolla .486 48.6% Total Average Capital $116,667 Appendix B 11/9/06 4:31 PM Page B-13

Distribution of Partnership Income and Losses | B-13

Distribution of Income Partner Income Ratio Share of Income S. Hancock $140,000 .514 $ 71,960 J. Rolla $140,000 .486 68,040 Total income $140,000

Notice that to determine the distribution of income (or losses), you must determine the average capital balances and the average capital balance ratios. To compute each partner’s average capital balance, you must examine the changes that have occurred during the year in each partner’s capital balance— changes that are the product of further investments and withdrawals. The partner’s beginning capital is multiplied by the number of months the balance remains unchanged. After the balance changes, the new balance is multiplied by the number of months it remains unchanged. The process continues until the end of the year. The totals of these computations are added and are then divided by 12 to determine the average capital balances. Once that is done, the method of figuring capital balance ratios for sharing income or losses is the same as the method used for beginning capital balances.

Salaries, Interest, and Stated Ratios Partners generally do not contribute equally to a firm. To make up for unequal contributions, a partnership agreement can allow for partners’ salaries, interest on partners’ capital balances, or a combination of both in the distribution of Partnership income or losses income. Again, salaries and interest of this kind are not deducted as expenses cannot be divided solely on the before the partnership income is determined. They represent a method of basis of salaries or interest. An arriving at an equitable distribution of income or loss. additional component, such as stated ratios, is needed. To illustrate an allowance for partners’ salaries, let’s assume that Hancock and Rolla agree to annual salaries of $8,000 and $7,000, respectively, and to divide any remaining income equally between them. Each salary is charged to the appropriate partner’s Withdrawals account when paid. Assuming the same $140,000 net income for the first year, the calculations for Hancock and Rolla are as follows:

Income of Partner Income Hancock Rolla Distributed Total Income for Distribution $140,000 Distribution of Salaries Hancock $ 8,000 Rolla $ 7,000(15,000 ) Remaining Income After Salaries $125,000 Equal Distribution of Remaining Income Hancock ($125,000 .50) 62,500 Rolla ($125,000 .50)62,500 (125,000 ) Remaining Income — Income of Partners $70,500 $69,500 $140,000

Salaries allow for differences in the services that partners provide the business. However, they do not take into account differences in invested capital. To Appendix B 11/9/06 4:31 PM Page B-14

B-14 | APPENDIX B Partnerships allow for these differences, each partner can be allowed, in addition to salary, a stated interest on his or her invested capital. Suppose that Sara Hancock and Joe Rolla agree to annual salaries of $8,000 and $7,000, respectively, as well as 10 percent interest on their beginning capital balances, and to share any remaining income equally. The calculations for Hancock and Rolla, assuming income of $140,000, are as follows:

Income of Partner Income Hancock Rolla Distributed

If there is a negative balance after Total Income for Distribution $140,000 salaries or salaries and interest Distribution of Salaries have been distributed, the terms Hancock $ 8,000 Remaining Income After Salaries Rolla $7,000(15,000 ) and Remaining Income After Salaries and Interest become Remaining Income After Salaries $125,000 Negative Balance After Salaries and Distribution of Interest Negative Balance After Salaries and Hancock ($65,000 .10) 6,500 Interest.The computation proceeds Rolla ($60,000 .10)6,000 (12,500 ) in exactly the same way, regardless of whether the balance is positive Remaining Income After Salaries and Interest $112,500 or negative. Equal Distribution of Remaining Income Hancock ($112,500 .50) 56,250 Rolla ($112,500 .50)56,250 (112,500 ) Remaining Income — Income of Partners $70,750 $69,250 $140,000

If the partnership agreement allows for the distribution of salaries or interest or both, the amounts must be allocated to the partners even if profits are

EXHIBIT 1 Partial Income Statement for Hancock & Rolla Jewelers Hancock & Rolla Jewelers Partial Income Statement For the Year Ended June 30, 2009 Net income $140,000 Distribution to the partners Hancock Salary distribution $70,000 Interest on beginning capital balance 6,500 Total $76,500 One-half of remaining negative amount(1,250 ) Share of net income $ 75,250 Using salaries and interest to Rolla divide income or losses among Salary distribution $60,000 partners has no effect on the income statement. They are not Interest on beginning capital balance 6,000 expenses. Partners’salaries and Total $66,000 interest are used only to allow the One-half of remaining negative amount(1,250 ) equitable division of the partnership’s net income or Share of net income 64,750 net loss. Net income distributed $140,000 Appendix B 11/9/06 4:31 PM Page B-15

Distribution of Partnership Income and Losses | B-15 not enough to cover the salaries and interest. In fact, even if the company has a net loss, these allocations must still be made. After the allocation of salaries and interest, the negative balance, or loss, must be distributed according to the stated ratio in the partnership agreement or equally if the agreement does not mention a ratio. For example, let’s assume that Hancock and Rolla agreed to the following conditions, with much higher annual salaries, for the distribution of income or losses:

Salaries Interest Beginning Capital Balance Hancock $70,000 10 percent of beginning $65,000 Rolla 60,000 capital balances 60,000

The computations for the distribution, again assuming net income of $140,000, are as follows:

Income of Partner Income Hancock Rolla Distributed Total Income for Distribution $140,000 Distribution of Salaries Hancock $70,000 Rolla $60,000(130,000 ) Remaining Income After Salaries $10,000 Distribution of Interest Hancock ($65,000 .10) 6,500 Rolla ($60,000 .10) 6,000(12,500 ) Negative Balance After Salaries and Interest ($2,500) Equal Distribution of Negative Balance* Hancock ($2,500 .50)(1,250 ) Rolla ($2,500 .50)(1,250 ) 2,500 Remaining Income — Income of Partners $75,250 $64,750 $140,000

*Notice that the negative balance is distributed equally because the agreement does not indicate how income and losses should be distributed after salaries and interest are distributed.

On the firm’s income statement, the distribution of income or losses appears below the net income figure. Exhibit 1 shows how this is done.

STOP• REVIEW• APPLY 3-1. What are three common bases for sharing income or losses in a partnership? 3-2. Do a partnership’s losses have to be divided in the same way as income? 3-3. If the total of partners’ salaries and interest exceeds the partnership’s total net income, how is the excess handled? Appendix B 11/9/06 4:31 PM Page B-16

B-16 | APPENDIX B Partnerships

Distribution of Partnership Income Kathy and Roger are partners. At the beginning of their firm’s fiscal year, the balances in their Capital accounts were $60,000 and $40,000, respectively. Kathy’s salary allowance is $12,000; Roger’s is $24,000. They are each allowed 5 percent interest on their beginning capital balances and share any remaining income equally. How much would each receive in a year in which the partnership earned $50,000?

SOLUTION Kathy Roger Salaries $12,000 $24,000 Interest 3,000 2,000 Remainder* 4,500 4,500 Total $19,500 $30,500

* [$50,000 ($36,000 $25,000)] 2 $4,500

Dissolution of a Partnership

LO4 Record a person’s admission to or withdrawal from a partnership.

he dissolution of a partnership occurs whenever there is a change in the original association of partners, as when a new partner is admitted to the Tfirm, a partner withdraws from the firm, or a partner dies. Dissolution is both a legal and accounting issue. When a partnership is dissolved, the partners lose their legal authority to continue the business as a going concern; from an accounting standpoint, the separate entity ceases to exist. Dissolution does not necessarily mean that the business will be inter- rupted or come to an end. The remaining partners can act for the partnership in finishing the affairs of the business or in forming a new partnership that will become a new accounting entity. Forming a new partnership requires the consent of all the remaining partners and the ratification of a new partnership agreement. Think of the number of legal changes that means for a firm like Ernst & Young, which admits over one hundred partners each year. Nonethe- less, Ernst & Young’s operations continue without interruption.

Admission of a Partner The admission of a partner dissolves the old partnership because a new association has been formed, and, as we have noted, it requires a new partnership agreement. An individual can be admitted to a partnership in one of two ways: Admission of a partner never has by purchasing an interest in the partnership from one or more of the original an impact on net income. partners or by investing assets in the partnership. Regardless of the price a new partner pays, income statement accounts never appear in the entry Purchasing an Interest from a Partner When a person purchases to record the admission of a new an interest in a partnership from an original partner, the transaction is a per- partner. sonal one between those two people. Because a partnership is a voluntary association, the remaining partners must approve of the sale. The interest purchased must be transferred from the Capital account of the selling partner to the Capital account of the new partner. Appendix B 11/9/06 4:31 PM Page B-17

Dissolution of a Partnership | B-17 Suppose that Sara Hancock decides to sell her interest of $70,000 in Han- cock & Rolla Jewelers to Manuel Hernandez for $100,000 on August 31, 2009, and that Joe Rolla agrees to the sale. The entry to record the sale on the partnership books looks like this:

A L OE 2009 Aug. 31 S. Hancock, Capital 70,000 M. Hernandez, Capital 70,000 Transfer of S. Hancock‘s equity to M. Hernandez

When a partner sells his or her interest directly to a new partner, Notice that the entry records the book value of the equity, not the amount Her- the partner, not the partnership, realizes the gain or loss. In this nandez pays. The amount Hernandez pays is a personal matter between Han- case, Hancock has a gain of cock and Hernandez. Because the amount paid does not affect the assets or $30,000, but the assets, liabilities, liabilities of the firm, it is not entered in the records. and total equity of the partnership do not change. Investing Assets in a Partnership When a person gains admission to a partnership by investing in the firm, both the assets and the partners’ equity in the firm increase. The increase occurs because the assets that the new partner invests become partnership assets, and as partnership assets increase, partners’ equity increases. For example, suppose that Sara Hancock and Joe Rolla have agreed to allow Manuel Hernandez to invest $75,000 in return for a one-third interest in their partnership. The Capital account balances of Sara Hancock and Joe Rolla are $70,000 and $80,000, respectively. Her- nandez’s $75,000 investment equals a one-third interest in the firm after the If at the time a new partner is investment is added to the previously existing capital of the partnership: admitted, the asset accounts do S. Hancock, Capital $ 70,000 not reflect fair market value, the asset accounts and the partners’ J. Rolla, Capital 80,000 Capital accounts must be adjusted M. Hernandez’s investment 75,000 before the new partner is Total capital after M. Hernandez’s investment $225,000 admitted. One-third interest $225,000 3 $ 75,000

The entry to record Hernandez’s investment is as follows:

2009 A L OE Aug. 31 Cash 75,000 M. Hernandez, Capital 75,000 Admission of M. Hernandez for a one-third interest in the partnership

Bonus to the Old Partners A partnership is sometimes so profitable or otherwise advantageous that a new investor is willing to pay more than the actual dollar interest he or she receives in the partnership. For instance, suppose a person pays $100,000 for an $80,000 interest in a partnership. The $20,000 excess of the payment over the interest purchased is a bonus to the original partners. The bonus must be distributed to the original partners according to the partnership agreement. If the agreement does not cover the distribution of bonuses, it should be distributed to the original partners in the same way income or losses are distributed. Appendix B 11/9/06 4:31 PM Page B-18

B-18 | APPENDIX B Partnerships Assume that Hancock & Rolla Jewelers has operated for several years and that the partners’ capital balances and the stated ratios for distribution of income or losses are as follows:

Partners Capital Balances Stated Ratios Hancock $160,000 55% Rolla 140,000 45% $300,000 100%

Manuel Hernandez wants to join the firm. He offers to invest $100,000 on December 1 for a one-fifth interest in the business and income. The original partners agree to the offer. This is the computation of the bonus to the original partners: Partners’ equity in the original partnership $300,000 Cash investment by M. Hernandez 100,000 Partners’ equity in the new partnership $400,000 Partners’ equity assigned to M. Hernandez $ 80,000 ($400,000 1/5) The original partners receive a Bonus to the original partners bonus because the entity is worth Investment by M. Hernandez $100,000 more as a going concern than the fair market value of the net assets Less equity assigned to M. Hernandez 80,000 $20,000 would otherwise indicate. In other Distribution of bonus to original partners words, the new partner is paying S. Hancock ($20,000 .55) $ 11,000 for unrecorded partnership value. J. Rolla ($20,000 .45) 9,000 $20,000

This entry records Hernandez’s admission to the partnership:

2010 A L OE Dec. 1 Cash 100,000 S. Hancock, Capital 11,000 J. Rolla, Capital 9,000 M. Hernandez, Capital 80,000 Investment by M. Hernandez for a one-fifth interest in the firm, and the bonus distributed to the original partners

Bonus to the New Partner There are several reasons why a partnership might want a new partner. A partnership in financial trouble might need additional cash; the partners might want to expand the firm’s markets and need more capital for this purpose than they themselves can provide; or they might want to admit a person who would bring a unique talent to the firm. Under these conditions, a new partner may be admitted to the firm with the understanding that part of the original partners’ capital will be transferred (credited) to the new partner’s Capital account as a bonus. For example, suppose Sara Hancock and Joe Rolla have invited Manuel Hernandez to join the firm. Hernandez is going to invest $60,000 on December 1 for a one-fourth interest in the company. The stated ratios for distribution of income or losses for Hancock and Rolla are 55 percent and 45 percent, respectively. The computation of Hernandez’s bonus is as follows: Appendix B 11/9/06 4:31 PM Page B-19

Dissolution of a Partnership | B-19 Total equity in partnership S. Hancock, Capital $160,000 J. Rolla, Capital 140,000 Investment by M. Hernandez 60,000 Partners’ equity in the new partnership $360,000 Partners’ equity assigned to M. Hernandez ($360,000 1/4) $ 90,000 Bonus to new partner Equity assigned to M. Hernandez $90,000 Less cash investment by M. Hernandez 60,000 $ 30,000 Distribution of bonus from original partners S. Hancock ($30,000 .55) $16,500 J. Rolla ($30,000 .45) 13,500 $ 30,000

The following entry records the admission of Manuel Hernandez to the partnership:

2010 A L OE Dec. 1 Cash 60,000 S. Hancock, Capital 16,500 J. Rolla, Capital 13,500 M. Hernandez, Capital 90,000 To record the investment by M. Hernandez of cash and a bonus from Hancock & Rolla

Withdrawal of a Partner Because a partnership is a voluntary association, a partner usually has the right to withdraw from the firm at any time. To avoid disputes when a partner does withdraw or retire, a partnership agreement should describe the procedures to be followed. The agreement should specify (1) whether an audit will be per- formed, (2) how the assets will be reappraised, (3) how a bonus will be determined, and (4) how the withdrawing partner will be paid. A partner can withdraw from a partnership in one of the following ways: By selling his or her interest to another partner or to an outsider with the consent of the remaining partners. By withdrawing assets equal to his or her capital balance, less than his or her capital balance (in this case, the remaining partners receive a bonus), or

FOCUS ON BUSINESS PRACTICE Can Withdrawal of Partners Harm a Partnership? The withdrawal of partners can put a financial strain on a Most Wall Street investment companies, including Mer- partnership. For example, Goldman, Sachs & Co.,the last rill Lynch and Salomon Brothers, are organized as cor- major Wall Street investment firm still organized as a part- porations. An advantage of the corporate form of business nership, had to scramble to raise more than $250 million is that when managers leave their jobs, they can sell their when 23 partners withdrew from the firm. Their with- stock without affecting the company’s capital. drawals caused a decrease in equity capital of about $400 million, which was almost 10 percent of the firm’s capital.5 Appendix B 11/9/06 4:31 PM Page B-20

B-20 | APPENDIX B Partnerships

■ FIGURE 1 Alternative Ways for a Partner to Withdraw

Sells to remaining partners Sells interest

Sells to new partner

Partner withdraws Withdraws assets equal to interest

Withdraws interest Withdraws assets less in partnership than interest; bonus to assets remaining partners

Withdraws assets greater than interest; bonus to departing partner

greater than his or her capital balance (in this case, the withdrawing partner receives a bonus). Figure 1 illustrates these alternative methods.

Withdrawal by Selling Interest When a partner sells his or her interest to another partner or to an outsider with the consent of the other partners, the transaction is personal; it does not change the partnership assets or the The only effect of a partner’s partners’ equity. For example, let’s assume that the capital balances of Han- selling his or her interest to the existing partners or to a new cock, Rolla, and Hernandez are $140,000, $100,000, and $60,000, respectively, partner is a change of names in the for a total of $300,000. partners’equity section of the Joe Rolla has announced that he wants to withdraw from the partnership. balance sheet. It does not affect Manuel Hernandez has offered to buy Rolla’s interest for $110,000, and Tari the partnership’s assets and Wang has offered to buy it for $120,000. Sara Hancock has agreed to either liabilities; thus, total equity remains transaction. Because Hernandez and Wang would pay for Rolla’s interest from the same. Similarly, a partner’s their personal assets, the partnership accounting records would show only the withdrawal has no effect on the transfer of Rolla’s interest to Hernandez or Wang. If Hernandez purchases partnership’s income statement. Rolla’s interest, the entry to record the transfer would be as follows:

J. Rolla, Capital 100,000 A L OE M. Hernandez, Capital 100,000 Sale of J. Rolla’s partnership interest to M. Hernandez

If Wang purchases Rolla’s interest, the following entry would be made:

A L OE J. Rolla, Capital 100,000 T. Wang, Capital 100,000 Sale of J. Rolla’s partnership interest to T. Wang Appendix B 11/9/06 4:31 PM Page B-21

Dissolution of a Partnership | B-21 Withdrawal by Removing Assets Suppose Manuel Hernandez decides to withdraw from the firm. The partnership agreement states that he can withdraw cash equal to his capital balance. If there is not enough cash to cover his withdrawal, he must accept a promissory note from the new partnership for the balance. Hernandez has a capital balance of $60,000. The remaining partners ask him to withdraw only $50,000 in cash now because the firm is experiencing a cash shortage; he agrees to this request. The following entry records Hernandez’s withdrawal:

A L OE Jan. 21 M. Hernandez, Capital 60,000 Cash 50,000 Notes Payable 10,000 Withdrawal of M. Hernandez from the partnership

Even if a bonus were involved, M. Hernandez’s Capital account Sometimes circumstances are such that a withdrawing partner departs with would be debited for $60,000 to assets that are not equal to his or her capital balance. This might happen, for eliminate it. instance, if the assets are not liquid or the partners want to dissolve the partnership quickly. When a withdrawing partner removes assets that are worth less than his or her capital balance, the equity that the partner leaves in the business is divided among the remaining partners according to their stated ratios. This distribution is considered a bonus to the remaining partners. When a withdrawing partner takes out assets that are worth more than his or her capital balance, the excess is treated as a bonus to the withdrawing partner. The remaining partners absorb the bonus according to their stated ratios. Alterna- tive arrangements can be spelled out in the partnership agreement.

Death of a Partner When a partner dies, the partnership is dissolved because the original association has changed. The partnership agreement should state the actions to be taken. Normally, the books are closed, and financial statements are prepared. Those steps are necessary to determine the capital balance of each partner on the date of the death. The agreement may also indicate whether an audit should be conducted, assets appraised, and a bonus recorded, as well as the procedures for settling with the deceased partner’s heirs. The remaining partners may purchase the deceased partner’s equity, sell it to outsiders, or deliver specified business assets to the estate. If the firm intends to continue, a new partnership must be formed.

STOP• REVIEW• APPLY 4-1. What is the dissolution of a partnership? 4-2. What are three actions that cause a partnership to dissolve? 4-3. What is the difference between a bonus to a new partner and bonuses to the original partners? 4-4. What are two ways, other than by death, that a partner can leave a partnership? Admission of a New Partner Dan and Augie each own a $50,000 interest in a partnership. They agree to admit Bea as a partner by selling her a one- third interest for $80,000. Who will get a bonus, and how large will it be? Appendix B 11/9/06 4:31 PM Page B-22

B-22 | APPENDIX B Partnerships

SOLUTION Current partners’ capital: Dan $ 50,000 Augie 50,000 Total partners’ capital $100,000 New partners’ capital computed: $100,000 $80,000 $180,000 $180,000/(1/3) $60,000 Each partner will have capital of $60,000. Bonuses computed: To Dan: $60,000 $50,000 $10,000 To Augie: $60,000 $50,000 $10,000

Liquidation of a Partnership

LO5 Compute and record the distribution of assets to partners when they liquidate their partnership.

he liquidation of a partnership is a special form of dissolution. When a partnership is liquidated, the business will not continue. The partnership Tagreement should indicate the procedures to be followed in ending the business. The process usually involves the following steps: 1. The partnership adjusts and closes its books, and any existing income or losses from operations are distributed among the partners. 2. The partnership sells its assets and pays its liabilities, or it distributes them to the partners 3. Any gain or loss on the sale of the assets is allocated to the partners according to their stated ratios. 4. As cash from the sale of assets becomes available, it is applied first to outside creditors, then to loans from partners, and finally to the partners’ capital balances. 5. A partner with a negative capital balance is obligated to pay the amount of the negative balance from personal assets. If the partner is unable to do so, the remaining partners must absorb the deficit.

FOCUS ON BUSINESS PRACTICE What Are the Risks of Being a Partner in an Accounting Firm? Partners in large accounting firms can make over $250,000 long as the partner chooses to stay in the partnership. For per year, and top partners can draw over $800,000. The instance, the investments of partners in the eminent incomes of partners in small accounting firms are often accounting firm of Arthur Andersen LLP were wiped out much lower. Unlike the income of a manager in a corpora- when the firm was liquidated after being convicted of tion, the income of a partner is not guaranteed; rather, it is destroying evidence in the Enron case (a judgment later based on the firm’s performance. Moreover, a partner must overturned by the U. S. Supreme Court). invest capital in the partnership,and that capital is at risk as Appendix B 11/9/06 4:31 PM Page B-23

Liquidation of a Partnership | B-23 Liquidation can have a variety of financial outcomes. Here, we look at two: assets sold for a gain and assets sold for a loss. In both cases, we assume that the firm of Hancock, Rolla, & Hernandez Jewelers has closed its books and that the following balance sheet exists before liquidation:

Hancock, Rolla, & Hernandez Jewelers Balance Sheet February 2, 2010 Assets Liabilities Cash $ 60,000 Accounts payable $120,000 Accounts receivable 40,000 Merchandise inventory 100,000 Partners’ Equity Plant assets (net)200,000 S. Hancock, Capital 85,000 J. Rolla, Capital 95,000 M. Hernadnez, Capital 100,000 Total liabilities and Total assets$400,000 partners’ equity $400,000

Sara Hancock and Joe Rolla have stated ratios of 30 percent, and Manuel Her- nandez has a stated ratio of 40 percent.

Gain on Sale of Assets The liquidation of Hancock, Rolla, & Hernandez Jewelers involved the following transactions: 1. The firm collected accounts receivable in the amount of $35,000. 2. It sold inventory for $110,000. 3. It sold plant assets for $200,000. 4. It paid accounts payable in the amount of $120,000. 5. It had a gain of $5,000 from the realization of the assets and distributed the gain to the partners according to their stated ratios. 6. It gave the partners cash amounts equal to the balances in their Capital accounts. Note the use of the term realization in item 5 in this list; realization means “con- version into cash.” Also, in item 6, note that the cash distributed to the partners is the balance in their respective Capital accounts. Cash is not distributed according to the partners’ stated ratios. The statement of liquidation in Exhibit 2 summarizes the six transactions involved in the firm’s liquidation. Journal entries for these transactions follow. (The numbers to the right of the journal entries correspond to the numbered entries in Exhibit 2.)

Related item in Exhibit 3

A L OE Cash 140,000 1. Gain or Loss from Realization 200,000 Accounts Receivable 40,000 Merchandise Inventory 100,000 Plant Assets (Net) 200,000 Collection of accounts receivable and the sale of inventory and plant assets*

*For the sake of conciseness, we use a compound entry here to cover entries 1, 2, and 3 in our earlier example of a gain.

A L OE Accounts Payable 120,000 2. Cash 120,000 Payment of accounts payable

A L OE S. Hancock, Capital 60,000 3. J. Rolla, Capital 60,000 M. Hernandez, Capital 80,000 Gain or Loss from Realization 200,000 Distribution of the loss on sale of assets to the partners

A L OE S. Hancock, Capital 25,000 4. J. Rolla, Capital 35,000 M. Hernandez, Capital 20,000 Cash 80,000 Distribution of cash to the partners

Because partners have unlimited liability, a partner whose capital balance is not large enough to cover his or her share of a loss occurring in a liquidation must make up the deficit from personal assets. For example, suppose that after Hancock, Rolla, & Hernandez Jewelers sells assets and pays liabilities, the remaining assets and partners’ equity look like this: Assets Cash $30,000 Partners’ Equity S. Hancock, Capital $25,000 J. Rolla, Capital 20,000 M. Hernandez, Capital(15,000 ) $30,000 Appendix B 11/9/06 4:31 PM Page B-27

Liquidation of a Partnership | B-27 Manuel Hernandez must pay $15,000 into the partnership from personal funds to cover his deficit. If Hernandez makes a cash payment, it would be recorded as follows:

A L OE Cash 15,000 M. Hernandez, Capital 15,000 Additional investment of M. Hernandez to cover the negative balance in his Capital account

After Hernandez pays the $15,000, the firm has enough cash to pay Hancock and Rolla their capital balances and thus complete the liquidation. The transaction is recorded this way:

A L OE S. Hancock, Capital 25,000 J. Rolla, Capital 20,000 Cash 45,000 Distribution of cash to the partners

If a partner does not have the means to cover his or her obligations to the partnership, the remaining partners share the loss according to their stated ratios. (Remember that all partners have unlimited liability.) Thus, if Manuel Hernandez cannot pay the $15,000 deficit in his Capital account, Hancock and Rolla must share the deficit according to their stated ratios. Each has a 30 percent stated ratio, so each must pay 50 percent of the losses that Hernandez cannot pay. The new stated ratios are computed as follows: Old Ratios New Ratios Hancock 30% 30 60 .50 50% Rolla30% 30 60 .50 50% 60% 100%

The entries to record the transactions are as follows:

A L OE S. Hancock, Capital 7,500 J. Rolla, Capital 7,500 M. Hernandez, Capital 15,000 Transfer of Hernandez’s deficit to Hancock and Rolla

A L OE S. Hancock, Capital 17,500 J. Rolla, Capital 12,500 Cash 30,000 Distribution of cash to the partners

Hernandez’s inability to meet his obligations at the time of liquidation does not relieve him of his obligations to Hancock and Rolla. If he is able to pay his debts in the future, Hancock and Rolla can collect from him the amount of his deficit that they absorbed. Appendix B 11/9/06 4:31 PM Page B-28

B-28 | APPENDIX B Partnerships

STOP• REVIEW• APPLY 5-1. What are the steps in the liquidation of a partnership? 5-2. Which accounts are increased or decreased by the gain or loss that results from the sale of assets and payment of liabilities in the liquidation process? 5-3. If a partnership has cash remaining after it has sold its assets and paid its liabilities, to which accounts must the cash be applied? 5-4. If a partner in a liquidating firm has a negative balance in his or her capital account and has personal assets, what actions must this person take?

A LOOK BACK AT ERNST & YOUNG In the Decision Point at the start of the chapter, we posed the following questions: ● How does a firm as large as Ernst & Young organize to accomplish its objectives? ● How does a partnership account for its partners’ interests? ● What happens when partners enter or withdraw from a partnership? Ernst & Young is organized as a limited liability partnership. In an ordinary partnership, the personal financial resources of all partners are at risk if the partnership suf- fers a loss it cannot bear. Accounting firms like Ernst & Young can suffer large losses as a result of lawsuits filed by investors who have lost money investing in a company that the firms have audited. But because Ernst & Young is organized as a limited liability partnership, the partners are liable only to the extent of their partnership interest in the firm; their personal assets are not at risk. In accounting for its partners’ interest, Ernst & Young accounts for partnership transactions in a manner similar to those illustrated in the text.However,because the firm is a large entity with hundreds of partners, the methods are much more complex. For example, the firm divides earnings among the partners each year based on complex formulas that take into account experience,performance,and other criteria. Also, because of its size, partners enter and leave the partnership frequently. As a result, detailed agreements are needed to specify what a partner’s interest is on entering and leaving the firm. Appendix B 11/9/06 4:31 PM Page B-29

Chapter Review | B-29 CHAPTER REVIEW REVIEW of Learning Objectives

LO1 Describe the characteristics A partnership has several characteristics that distinguish it from the other of partnerships and related forms forms of business. It is a voluntary association of two or more people who com- of business. bine their talents and resources to carry on a business. The advantages of a partnership are that it is easy to form, change and dissolve; it facilitates the pooling of capital resources and individual talents; it has no corporate tax burden; and it gives the partners a certain amount of freedom and flexibility. Its disadvantages are that it has a limited life, one partner can bind the partnership to a contract (mutual agency), the partners have unlimited personal liability for the debts of the business, and it is more difficult for a partnership to raise large amounts of capital and transfer ownership than it is for a corporation. To maximize the advantages of a partnership and minimize the disadvantages, the partners must have a carefully planned partnership agreement that covers various contingencies. Important considerations affecting a partnership agreement are limited life, mutual agency, unlimited liability, co-ownership of property, participation in income or losses, and the terms of dissolution and liquidation. Various types of partnerships overcome some of the disadvantages of the basic form. They include limited partnerships, limited liability partnerships, joint ventures, S corporations, limited liability corporations, and special- purpose entities.

LO2 Record partners’invest- A partnership is formed when the partners contribute cash, other assets, or ments of cash and other assets both to the business. The details are stated in the partnership agreement. Ini- when a partnership is formed. tial investments are recorded with a debit to Cash or other asset accounts and a credit to the investing partner’s Capital account. Assets other than cash should be recorded at their fair market value on the date of transfer to the partnership. A partnership can also assume an investing partner’s liabilities. When this occurs, the partner’s Capital account is credited with the difference between the assets invested and the liabilities assumed.

LO3 Use stated ratios, capital Partners must share income and losses in accordance with the partnership balance ratios, and partners’ agreement. If the agreement says nothing about the distribution of income and salaries and interest to compute losses, the partners share them equally. Common methods used for distribut- the income or losses that partners ing income and losses include stated ratios, capital balance ratios, and salaries share. and interest on capital investments. Each method tries to measure the individual partner’s contribution to the business. Stated ratios usually are based on the partners’ relative contributions to the partnership. When capital balance ratios are used, income or losses are divided strictly on the basis of each partner’s capital balance. The use of salaries and interest on capital investments takes into account both efforts (salaries) and capital investment (interest) in dividing income or losses among the partners.

LO4 Record a person’s admis- A person can be admitted to a partnership by purchasing a partner’s interest or sion to or withdrawal from a by investing assets in the business. When a person purchases an interest from partnership. an original partner, the interest purchased is transferred from the Capital account of the selling partner to the Capital account of the new partner. When the new partner contributes assets to the partnership, it may be necessary to record a bonus shared or borne by the original partners or by the new partner. Appendix B 11/9/06 4:31 PM Page B-30

B-30 | APPENDIX B Partnerships A person can withdraw from a partnership by selling his or her interest in the business to the remaining partners or to a new partner or by withdrawing company assets. When assets are withdrawn, the amount can be equal to, less than, or greater than the partner’s capital interest. When assets that have a value less than or greater than the partner’s interest are withdrawn, a bonus is recognized and distributed among the remaining partners or to the departing partner.

LO5 Compute and record the The liquidation of a partnership entails selling the assets necessary to pay the distribution of assets to partners company’s liabilities and distributing any remaining assets to the partners. Any when they liquidate their gain or loss on the sale of the assets is shared by the partners according to their partnership. stated ratios. When a partner has a deficit balance in a Capital account, that partner must contribute personal assets equal to the deficit. When a partner does not have enough personal assets to cover a capital deficit, the deficit must be absorbed by the solvent partners according to their stated ratios.

REVIEW of Concepts and Terminology

The following concepts and terms were introduced in the liability of the other partners is limited to the this chapter: amount of their investments in the firm. (LO1) Bonus: An amount that accrues to the original part- Liquidation: A special form of dissolution in which a ners when a new partner pays more to the partner- partnership ends by selling assets, paying liabili- ship than the interest received or that accrues to ties, and distributing any remaining assets to the the new partner when the amount paid to the part- partners. (LO5) nership is less than the interest received. (LO4) Mutual agency: A characteristic of a partnership; the Dissolution: The loss of legal authority to continue a authority of each partner to act as an agent of the partnership and the cessation of the partnership as partnership within the scope of the business’s nor- a separate accounting entity caused by a change in mal operations. (LO1) the original association of partners. (LO4) Partners’ equity: The owner’s equity in a partnership. Joint venture: A partnership in which two or more (LO2) entities collaborate to achieve a specific goal. Partnership: An association of two or more people to (LO1) carry on as co-owners of a business for profit. (LO1) Limited liability corporations (LLCs): Corporations Partnership agreement: The contractual relationship that resemble LLPs and that are used by profes- between partners that identifies the details of their sional firms to limit the liability of the partners. partnership. (LO1) (LO1) S corporations: Corporations that U.S. tax laws treat Limited liability partnerships (LLPs): Partnerships as partnerships. (LO1) authorized by state law and used by professional Special-purpose entities (SPEs): Firms with limited firms to limit the liability of the partners. (LO1) lives that are created to achieve a specific objec- Limited life: A characteristic of a partnership; the fact tive of the parent company. (LO1) that any event that breaches the partnership agree- Unlimited liability: A characteristic of a partnership; ment—including the admission, withdrawal, or death the fact that each partner is personally liable for all of a partner—terminates the partnership. (LO1) the debts of the partnership. (LO1) Limited partnership (LP): A type of partnership in which a general partner has unlimited liability and

REVIEW Problem

LO3, LO4 Distribution of Income and Loss, and Admission of a Partner Tanner Foster and Frank Costa reached an agreement in 20x7 to pool their resources and form a partnership to manufacture and sell university T-shirts. To Appendix B 11/9/06 4:31 PM Page B-31

Chapter Review | B-31 form the partnership, Foster and Costa contributed $100,000 and $150,000, respectively. Their partnership agreement stated that Foster was to receive an annual salary of $6,000, that Costa was to receive 3 percent interest annually on his original investment of $150,000, and that the two partners were to share any remaining income and losses in a ratio of 2 to 3 (40 percent and 60 percent, respectively). Required 1. In 20x7, the partnership had an income of $27,000, and in 20x8, it had a loss of $2,000 (before salaries and interest). Compute Tanner Foster and Frank Costa’s share of the income and loss, and prepare the required entries in journal form. 2. On January 2, 20x9, Jane Collins offers Foster and Costa $60,000 for a 15 percent interest in the partnership. Foster and Costa accept Collins’s offer because they need her resources to expand the business. On January 1, 20x9, the balance in Foster’s Capital account is $113,600, and the balance in Costa’s Capital account is $161,400. Assuming that Collins’s investment represents a 15 percent interest in the total partners’ capital and that a bonus will be distributed to Foster and Costa in the ratio of 2:3, record Collins’s admission to the partnership.

Answer to Review Problem 1. Income and losses shared by the partners: Appendix B 11/9/06 4:31 PM Page B-32

B-32 | APPENDIX B Partnerships

2. Admission of the new partner: Appendix B 11/9/06 4:31 PM Page B-33

Chapter Assignments | B-33 CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills

Short Exercises LO1 Partnership Characteristics SE 1. Indicate whether each statement below is a reflection of (a) voluntary association, (b) a partnership agreement, (c) limited life, (d) mutual agency, or (e) unlimited liability. 1. A partner may be required to pay the debts of the partnership out of personal assets. 2. A partnership must be dissolved when a partner is admitted, withdraws, retires, or dies. 3. Any partner can bind the partnership to a business agreement. 4. A partner does not have to remain a partner if he or she does not want to. 5. Details of the arrangements among partners are specified in a written contract.

LO2 Partnership Formation SE 2. To form a new partnership, Sue contributes cash of $24,000, and Marty contributes office equipment that cost $20,000 but is valued at $8,000. Prepare the entry in journal form to form the partnership. LO3 Distribution of Partnership Income SE 3. During the first year, the Sue and Marty partnership (see SE 2) earned an income of $10,000. Assume the partners agreed to share income and losses in the ratio of the beginning balances of their capital accounts. How much income should be transferred to each Capital account? LO3 Distribution of Partnership Income SE 4. During the first year, the Sue and Marty partnership (see SE 2) earned an income of $10,000. Assume the partners agreed to share income and losses by figuring interest on the beginning capital balances at 10 percent and dividing the remainder equally. How much income should be transferred to each Capital account? LO3 Distribution of Partnership Income SE 5. During the first year, the Sue and Marty partnership (see SE 2) earned an income of $10,000. Assume the partners agreed to share income and losses by figuring interest on the beginning capital balances at 10 percent, allowing a salary of $12,000 to Sue, and dividing the remainder equally. How much income (or loss) should be transferred to each Capital account? LO3 Withdrawal of a Partner and Admission of a Partner SE 6. After the partnership has been operating for a year, the Capital accounts of Sue and Marty are $30,000 and $20,000, respectively. Marty withdraws from the partnership by selling his interest in the business to Tina for $16,000. What will be the Capital account balances of the partners in the new Sue and Tina partnership? Prepare the entry in journal form to record the transfer of ownership on the partnership books. Appendix B 11/9/06 4:31 PM Page B-34

B-34 | APPENDIX B Partnerships LO4 Admission of a New Partner SE 7. After the partnership has been operating for a year, the Capital accounts of Sue and Marty are $30,000 and $20,000, respectively. Tina buys a one- sixth interest in the partnership by investing cash of $22,000. What will be the Capital account balances of the partners in the new Sue, Marty, and Tina partnership, assuming a bonus to the old partners, who share income and losses equally? Prepare the entry in journal form to record the transfer of ownership on the partnership books.

LO4 Admission of a New Partner SE 8. After the partnership has been operating for a year, the Capital accounts of Sue and Marty are $30,000 and $20,000, respectively. Tina buys a one- fourth interest in the partnership by investing cash of $10,000. What will be the Capital account balances of the partners in the new Sue, Marty, and Tina partnership, assuming that the new partner receives a bonus and that Sue and Marty share income and losses equally? Prepare the entry in journal form to record the transfer of ownership on the partnership books.

LO4 Withdrawal of a Partner SE 9. After the partnership has been operating for several years, the Capital accounts of Sue, Marty, and Tina are $50,000, $32,000, and $18,000, respectively. Tina decides to leave the partnership and is allowed to withdraw $18,000 in cash. Prepare the entry in journal form to record the withdrawal on the partnership books.

LO5 Liquidation of a Partnership SE 10. After the partnership has been operating for a year, the Capital accounts of Sue and Marty are $30,000 and $20,000, respectively. The firm has cash of $24,000 and office equipment of $26,000. The partners decide to liquidate the partnership. The office equipment is sold for only $8,000. Assuming the partners share income and losses in the ratio of one-third to Sue and two-thirds to Marty, how much cash will be distributed to each partner in liquidation?

Exercises LO1, LO2 Discussion Questions E 1. Develop brief answers to each of the following questions: 1. Why is it important for people to form partnerships with people whom they can trust? 2. Leon and Jon are partners in a drilling operation. Leon purchased a drilling rig to be used in the partnership’s operations. Is Leon’s purchase binding on Jon even though Jon was not involved in the purchase? Explain your answer. 3. When accounts receivable are transferred into a partnership, at what amount should they be recorded?

LO3, LO4, LO5 Discussion Questions E 2. Develop brief answers to each of the following questions: 1. What is a disadvantage of receiving a large salary as part of a partner’s distribution of income? Appendix B 11/9/06 4:31 PM Page B-35

Chapter Assignments | B-35 2. If the value of a partnership is worth far more than the book value of the assets on the balance sheet, would a new partner entering the partnership be more likely to pay a bonus to the old partners or receive a bonus from the old partners? 3. Carol purchases Mary’s interest in the Mary and Leo partnership by paying Mary $62,000. Mary has a $57,000 capital account on the partnership books. After the transaction, what is Carol’s Capital account balance on the partnership books? 4. When a partnership is dissolved, what is an alternate approach to selling all the assets and distributing the proceeds, and what decisions will have to be made if this approach is taken?

LO1 Types of Partnerships and Related Forms of Business Organization E 3. Indicate whether each statement below is applicable to a (a) limited partnership, (b) limited liability partnership (LLP), (c) joint venture, (d) S corporation, (e) limited liability corporation (LLC), or (f) special-purpose entity (SPE). 1. Created by law to tax a corporation like a partnership 2. Created by law to be a corporation that is similar in nature to an LLP 3. Created by law to limit the liability of partners in professional services firms 4. Used often in real estate ventures to limited the liability of all partners except the general partner 5. Used by businesses to separate assets and debt from the companies‘ balance sheet and made famous by Enron 6. Used mostly by corporations and governments to work together in international projects

LO2 Partnership Formation E 4. Mikel and Jami want to form a partnership and open a jewelry store. They have an attorney prepare their partnership agreement, which indicates that assets invested in the partnership will be recorded at their fair market value and that liabilities will be assumed at book value. The assets contributed by each partner and the liabilities assumed by the partnership are as follows: Assets Mikel Jami Total Cash $40,000 $30,000 $70,000 Accounts receivable 52,000 20,000 72,000 Allowance for uncollectible accounts 4,000 3,000 7,000 Supplies 1,000 500 1,500 Equipment 20,000 10,000 30,000 Liabilities Accounts payable 32,000 9,000 41,000 Prepare the entry in journal form necessary to record the original investments of Mikel and Jami in the partnership.

LO3 Distribution of Income E 5. Turner and Isham agree to form a partnership. Turner contributes $200,000 in cash, and Isham contributes assets with a fair market value of $400,000. The partnership, in its initial year, reports net income of $120,000. Calcu- late the distribution of the first year’s income to the partners under each of the conditions that follow. Appendix B 11/9/06 4:31 PM Page B-36

B-36 | APPENDIX B Partnerships 1. Turner and Isham fail to include stated ratios in the partnership agreement. 2. Turner and Isham agree to share income and losses in a 3:2 ratio. 3. Turner and Isham agree to share income and losses in the ratio of their original investments. 4. Turner and Isham agree to share income and losses by allowing 10 percent interest on original investments and sharing any remainder equally.

LO3 Distribution of Income or Losses: Salaries and Interest E 6. Assume that the partnership agreement of Turner and Isham in E 5 states that Turner and Isham are to receive salaries of $20,000 and $24,000, respectively; that Turner is to receive 6 percent interest on his capital balance at the beginning of the year; and that the remainder of income and losses are to be shared equally. Calculate the distribution of the income or losses under the following conditions: 1. Income totals $120,000. 2. Income totals $48,000. 3. There is a loss of $2,000. 4. There is a loss of $40,000.

LO3 Distribution of Income: Average Capital Balance E 7. Mark and Kevin operate a furniture rental business. Their capital balances on January 1, 20x7, are $160,000 and $240,000, respectively. Mark withdraws cash of $32,000 from the business on April 1, 20x7. Kevin withdraws $60,000 cash on October 1, 20x7. Mark and Kevin distribute partnership income based on their average capital balances each year. Income for 20x7 is $160,000. Compute the income to be distributed to Mark and Kevin using their average capital balances in 20x7.

LO4 Admission of a New Partner: Recording a Bonus E 8. Ernie, Ron, and Denis have equity in a partnership of $40,000, $40,000, and $60,000, respectively, and they share income and losses in a ratio of 1:1:3. The partners have agreed to admit Henry to the partnership. Prepare entries in journal form to record the admission of Henry to the partnership under the following conditions: 1. Henry invests $60,000 for a 20 percent interest in the partnership, and a bonus is recorded for the original partners. 2. Henry invests $60,000 for a 40 percent interest in the partnership, and a bonus is recorded for Henry.

LO4 Withdrawal of a Partner E 9. Danny, Steve, and Luis are partners. They share income and losses in the ratio of 3:2:1. Luis’s Capital account has a $120,000 balance. Danny and Steve have agreed to let Luis take $160,000 of the company’s cash when he retires from the business. What entry in journal form must be made on the partnership’s books when Luis retires, assuming that a bonus to Luis is recognized and absorbed by the remaining partners? LO5 Partnership Liquidation E 10. Assume the following assets, liabilities, and partners’ equity in the Ming and Demmick partnership on December 31, 20xx: Other Assets Liabilities Ming, Capital Demmick, Capital $160,000 $10,000 $90,000 $60,000 Appendix B 11/9/06 4:31 PM Page B-37

Chapter Assignments | B-37 The partnership has no cash. When the partners agree to liquidate the business, the assets are sold for $120,000, and the liabilities are paid. Ming and Demmick share income and losses in a ratio of 3:1. 1. Prepare a statement of liquidation. 2. Prepare entries in journal form for the sale of assets, payment of liabilities, distribution of loss from realization, and final distribution of cash to Ming and Demmick.

LO5 Partnership Liquidation E 11. Ariel, Mandy, and Tisha are partners in a tanning salon. The assets, liabilities, and capital balances as of July 1, 20x7, are as follows: Other Assets $480,000 Liabilities 160,000 Ariel, Capital 140,000 Mandy, Capital 40,000 Tisha, Capital 140,000 Because competition is strong, business is declining, and the partnership has no cash, the partners have decided to sell the business. Ariel, Mandy, and Tisha share income and losses in a ratio of 3:1:1, respectively. The assets are sold for $260,000, and the liabilities are paid. Mandy has no other assets and will not be able to cover any deficits in her Capital account. How will the ending cash balance be distributed to the partners?

Problems LO2, LO3 Partnership Formation and Distribution of Income P 1. In January 20x7, Hana Marova and Jitma Beatty agree to produce and sell chocolate candies. Marova contributes $240,000 in cash to the business. Beatty contributes the building and equipment, valued at $220,000 and $140,000, respectively. The partnership has an income of $96,000 during 20x7 but is less successful during 20x8, when income is only $36,000. Required 1. Prepare the entry in journal form to record the investment of both partners in the partnership. 2. Determine the share of income for each partner in 20x7 and 20x8 under each of the following conditions: a. The partners agree to share income equally. b. The partners fail to agree on an income-sharing arrangement. c. The partners agree to share income according to the ratio of their original investments. d. The partners agree to share income by allowing interest of 10 percent on their original investments and dividing the remainder equally. e. The partners agree to share income by allowing salaries of $40,000 for Marova and $28,000 for Beatty, and dividing the remainder equally. f. The partners agree to share income by paying salaries of $40,000 to Marova and $28,000 to Beatty, allowing interest of 9 percent on their original investments, and dividing the remainder equally. 3. User Insight: What are some of the factors that need to be considered in choosing the plan of partners’ income sharing among the options shown in Part 2? Appendix B 11/9/06 4:31 PM Page B-38

B-38 | APPENDIX B Partnerships Distribution of Income: Salaries and Interest P 2. Adam, Issac, and Daniel are partners in the Three Friends Company. The partnership agreement states that Adam is to receive 8 percent interest on his capital balance at the beginning of the year, Issac is to receive a salary of $100,000 a year, and Daniel will be paid interest of 6 percent on his average capital balance during the year. Adam, Issac, and Daniel will share any income or loss after salary and interest in a 5:3:2 ratio. Adam’s capital balance at the beginning of the year is $600,000, and Daniel’s average capital balance for the year is $720,000. Required 1. Determine each partner’s share of income and losses under the following conditions. In each case, the income or loss is stated before the distribution of salary and interest. a. Income is $375,800. b. Income is $105,400. c. The loss is $46,200. 2. User Insight: What disadvantages can you suggest for having a stated ratio in the partnership agreement for distribution of income or losses?

LO4 Admission and Withdrawal of a Partner P 3. Abby, Anna, and Anita are partners in the Fio Fashions Store. As of Novem- ber 30, 20xx, the balance in Abby’s Capital account is $50,000, the balance in Anna’s is $60,000, and the balance in Anita’s is $90,000. Abby, Anna, and Anita share income and losses in a ratio of 2:3:5. Required 1. Prepare entries in journal form for each of the following independent conditions: a. Alice pays Anita $100,000 for four-fifths of Anita’s interest. b. Alice is to be admitted to the partnership with a one-third interest for a $100,000 cash investment. c. Alice is to be admitted to the partnership with a one-third interest for a $160,000 cash investment. A bonus, based on the partners’ ratio for income and losses, is to be distributed to the original partners when Alice is admitted. d. Alice is to be admitted to the partnership with a one-third interest for an $82,000 cash investment. A bonus is to be given to Alice on admission. e. Abby withdraws from the partnership, taking $66,000 in cash. f. Abby withdraws from the partnership by selling her interest directly to Alice for $70,000. 2. User Insight: In general, when a new partner enters a partnership, why would the new partner pay a bonus to the old partners, or why would the old partners pay a bonus to the new partner?

LO1, LO5 Partnership Liquidation P 4. The balance sheet of the JLJ Partnership as of July 31, 20xx, appears at the top of the opposite page. The partners in the firm—Juan, Lillian, and Joseph—share income and losses in the ratio of 5:3:2. Because of a mutual disagreement, Juan, Lillian, and Joseph have decided to liquidate the business. Appendix B 11/9/06 4:31 PM Page B-39

Chapter Assignments | B-39

JLJ Partnership Balance Sheet July 31, 20xx

Assets Liabilities Cash $ 6,000 Accounts payable $480,000 Accounts receivable 120,000 Inventory 264,000 Partners’ Equity Equipment (net)462,000 Juan, Capital 72,000 Lillian, Capital 180,000 Joseph, Capital 120,000 Total liabilities and Total assets$852,000 partners’ equity $852,000

Assume that Juan cannot contribute any additional personal assets to the company during liquidation and that the following transactions occurred during liquidation: a. Accounts receivable were sold for 66 2/3 percent of their book value. b. Inventory was sold for $276,000. c. Equipment was sold for $300,000. d. Accounts payable were paid in full. e. Gain or loss from realization was distributed to the partners’ Capital accounts. f. Juan’s deficit was transferred to the remaining partners in their new income and loss ratio. g. The remaining cash was distributed to Lillian and Joseph. Required 1. Prepare a statement of liquidation. 2. Prepare entries in journal form to liquidate the partnership and distribute any remaining cash. 3. User Insight: What disadvantage of the partnership form of business is reflected in this problem?

LO1, LO2, LO3, LO4, LO5 Comprehensive Partnership Transactions P 5. The following events pertain to a partnership formed by Mason Wilkes and Jiri Crevetz to operate a landscaping company: 20x7 Feb. 14 The partnership is formed. Wilkes transfers to the partnership $80,000 cash, land worth $80,000, a building worth $480,000, and a mortgage on the building of $240,000. Crevetz transfers to the partnership $40,000 cash and equipment worth $160,000. Dec. 31 During 20x7, the partnership earns income of just $84,000. The partnership agreement specifies that income and losses are to be divided by allowing salaries of $40,000 to Wilkes and $60,000 to Crevetz, allowing 8 percent interest on beginning capital investments, and dividing any remainder equally. 20x8 Jan. 1 To improve the prospects for the company, the partners decide to take in a new partner, John Houser, who has experience in the Appendix B 11/9/06 4:31 PM Page B-40

B-40 | APPENDIX B Partnerships landscaping business. Houser invests $156,000 for a 25 percent interest in the business. A bonus is transferred in equal amounts from the original partners’ Capital accounts to Houser’s Capital account. Dec. 31 During 20x8, the company earns income of $87,200. The new partnership agreement specifies that income and losses will be divided by allowing salaries of $60,000 to Crevetz and $80,000 to Houser (no salary to Wilkes), allowing 8 percent interest on beginning capital balances after Houser’s admission, and dividing the remainder equally. 20x9 Jan. 1 Because it appears that the business cannot support the three partners, the partners decide to liquidate the partnership. The asset and liability accounts of the partnership are as follows: Cash, $407,200; Accounts Receivable (net), $68,000; Land, $80,000; Build- ing (net), $448,000; Equipment (net), $236,000; Accounts Payable, $88,000; and Mortgage Payable, $224,000. The equipment is sold for $200,000. The accounts payable are paid. The loss is distributed equally to the partners’ Capital accounts. A statement of liquidation is prepared, and the remaining assets and liabilities are distributed. Wilkes agrees to accept cash plus the land and building at book value and the mortgage payable as payment for his share. Crevetz accepts cash and the accounts receivable for his share. Houser is paid in cash. Required 1. Prepare entries in journal form to record all of the facts above. Support your computations with schedules, and prepare a statement of liquidation in connection with the January 1, 20x9 entries. 2. User Insight: What principal issues should a partnership agreement normally address? What flaw can you suggest in the partnership agreement for sharing income and losses that may have doomed this partnership from the start? Explain your answer.

Alternate Problems LO3 Distribution of Income: Salaries and Interest P 6. Jan and Pat are partners in a tennis shop. They have agreed that Jan will operate the store and receive a salary of $104,000 per year. Pat will receive 10 percent interest on her average capital balance during the year of $500,000. The remaining income or losses are to be shared by Jan and Pat in a 2:3 ratio. Required 1. Determine each partner’s share of income and losses under each of the following conditions. In each case, the income or loss is stated before the distribution of salary and interest. a. Income is $238,000 b. Income is $76,000. c. The loss is $30,800. 2. User Insight: What does the partnership agreement on sharing of profits and losses recognize about the nature of the contributions of the partners to the partnership goals? Is either partner at a disadvantage? Appendix B 11/9/06 4:31 PM Page B-41

Chapter Assignments | B-41 LO4 Admission and Withdrawal of a Partner P 7. Misa, Sasha, and Serge are partners in MSS Company. Their capital balances as of July 31, 20x7, are as follows: Misa, Capital Sasha, Capital Serge, Capital 45,000 15,000 30,000 Each partner has agreed to admit Pavel to the partnership. Required 1. Prepare entries in journal form to record Pavel’s admission to or Misa’s withdrawal from the partnership under each of these conditions: a. Pavel pays Misa $12,500 for 20 percent of Misa’s interest in the partnership. b. Pavel invests $20,000 cash in the partnership and receives an interest equal to her investment. c. Pavel invests $30,000 cash in the partnership for a 20 percent interest in the business. A bonus is to be recorded for the original partners on the basis of their capital balances. d. Pavel invests $30,000 cash in the partnership for a 40 percent interest in the business. The original partners give Pavel a bonus according to the ratio of their capital balances on July 31, 20x7. e. Misa withdraws from the partnership, taking $52,500. The excess of withdrawn assets over Misa’s partnership interest is distributed according to the balances of the Capital accounts. f. Misa withdraws by selling her interest directly to Pavel for $60,000. 2. User Insight: When a new partner enters a partnership, why would the new partner pay a bonus to the old partners, or why would the old partners pay a bonus to the new partner? LO5 Partnership Liquidation P 8. Sander, Tailor, and Zansky are partners in a retail hardware store. They share income and losses in the ratio of 2:2:1, respectively. The partners have agreed to liquidate the partnership. Here is the partnership balance sheet before the liquidation:

Sander, Tailor, and Zansky Balance Sheet August 31, 20x8 Assets Liabilities Cash $ 280,000 Accounts payable $ 360,000 Other assets 880,000 Partners’ Equity Sander, Capital 400,000 Tailor, Capital 240,000 Zansky, Capital 160,000 Total liabilities and Total assets$1,160,000 partners’ equity $1,160,000

The other assets are sold on September 1, 20x8, for $180,000. Accounts payable are paid on September 4, 20x8. The remaining cash is distributed to the partners on September 11, 20x8. Appendix B 11/9/06 4:31 PM Page B-42

B-42 | APPENDIX B Partnerships Required 1. Prepare a statement of liquidation. 2. Prepare the following entries in journal form: a. The sale of the other assets b. Payment of the accounts payable c. The distribution of the loss from realization d. The allocation of negative balance in Tailor’s Capital account assuming Tailor has no assets e. The distribution to the partners of the remaining cash 3. User Insight: Which partner would be more vulnerable if the loss from realization had been larger? Explain your answer.

ENHANCING Your Knowledge, Skills, and Critical Thinking Conceptual Understanding Cases LO3 Distribution of Partnership Income and Losses C 1. Landow, Donovan, and Hansa, who are forming a partnership to operate an antiques gallery, are discussing how income and losses should be distributed. They hire you as the partnership’s accountant to advise them on an equitable plan for distributing income and losses. Among the facts you are considering are the following: a. Landow will contribute cash for operations of $100,000, Donovan will contribute a collection of antiques that is valued at $300,000, and Hansa will not contribute any assets. b. Landow and Hansa will handle day-to-day business operations. Hansa will work full time, and Landow will devote about half-time to the partnership. Donovan will not devote time to day-to-day operations. A full-time clerk in a retail store would make about $20,000 in a year, and a full-time manager would receive about $30,000. c. The current interest rate on long-term bonds is 8 percent. Suggest a plan and outline the reasons why you believe this plan is equitable. According to your plan, which partner will gain the most if the partnership is very profitable, and which will lose the most if the partnership has large losses? LO1 International Joint Ventures C 2. Nokia, the Finnish telecommunications company, has formed an equally owned joint venture with Capital Corporation, a state-owned Chinese company, to develop a center for the manufacture of telecommunications equipment in China, the world’s fastest-growing market for this kind of equipment. The Chinese government looks favorably on companies that involve local suppliers,6 and a main objective of this joint venture is to persuade Nokia’s suppliers to move close to the company’s main plant. What advantages does a joint venture have over a single company in entering a new market in another country? What are the potential disadvantages?

Interpreting Financial Reports LO1, LO3 Effects of Lawsuit on Partnership C 3. The Springfield Clinic is owned and operated by ten local doctors as a partnership. Recently, a paralyzed patient sued the clinic for malpractice, for a Appendix B 11/9/06 4:31 PM Page B-43

Chapter Assignments | B-43 total of $20 million. The clinic carries malpractice liability insurance in the amount of $10 million. There is no provision for the possible loss from this type of lawsuit in the partnership’s financial statements. The condensed balance sheet for 20xx is as follows:

Springfield Clinic Condensed Balance Sheet December 31, 20xx Assets Current assets $246,000 Property, plant, and equipment (net) 750,000 Total assets $996,000

Liabilities and Partners’ Equity Current liabilities $180,000 Long-term debt 675,000 Total liabilities $855,000 Partners’ equity 141,000 Total liabilities and partners’ equity $996,000

1. How should information about the lawsuit be disclosed in the December 31, 20xx, financial statements of the partnership? 2. Assume that the clinic and its insurance company settle out of court by agreeing to pay a total of $10.1 million, of which $100,000 must be paid by the partnership. What effect will the payment have on the clinic’s Decem- ber 31, 20xx, financial statements? Discuss the effect of the settlement on the Springfield Clinic doctors’ personal financial situations.

Decision Analysis Using Excel LO4 Potential Partnership Purchase C 4. The A-One Fitness Center, owned by Abe Hines and Mario Saconi, has been very successful since its formation five years ago. Hines and Saconi work 10 to 11 hours a day at the business. They have decided to expand by opening up another fitness center in the north part of town. Hines has approached you about becoming a partner in the business. He and Saconi are interested in you because of your experience in operating a small gym. Also, they need additional funds to expand their business. Projected income after the expansion but before partners’ salaries for the next five years is as follows: 2007 2008 2009 2010 2011 $100,000 $120,000 $130,000 $140,000 $150,000 Currently, Hines and Saconi each draw a $25,000 salary and share remaining profits equally. They are willing to give you an equal share of the business for $142,000. You would receive a $25,000 salary and one-third of the remaining profits. You would work the same hours as Hines and Saconi. Your salary for the next five years where you currently work is expected to be as follows: 2007 2008 2009 2010 2011 $34,000 $38,000 $42,000 $45,000 $50,000 Appendix B 11/17/06 5:51 PM Page B-44

B-44 | APPENDIX B Partnerships Here is financial information for the A-One Fitness Center: Current Assets $ 45,000 Plant and Equipment, net 365,000 Current Liabilities 50,000 Long-Term Liabilities 100,000 Abe Hines, Capital 140,000 Mario Saconi, Capital 120,000 1. Compute your capital balance if you decide to join Hines and Saconi in the fitness center partnership. 2. Analyze your expected income for the next five years. 3. Should you invest in the A-One Fitness Center? 4. Assume that you do not consider Hines and Saconi’s offer of partnership to be a good one. Develop a counteroffer that you would be willing to accept (be realistic).

Ethical Dilemma Case LO1, LO2, LO4 Death of a Partner C 5. South Shore Realty was started 20 years ago when T. S. Tyler, R. C. Strong, and A. J. Hibbert established a partnership to sell real estate near Galveston, Texas. The partnership has been extremely successful. In 20xx, Tyler, the senior partner, who in recent years had not been very active in the partnership, died. Unfortunately, the partnership agreement is vague about how the partnership interest of a partner who dies should be valued. It simply states that “the estate of a deceased partner shall receive compensation for his or her interest in the partnership in a reasonable time after death.” The attorney for Tyler’s family believes that the estate should receive one-third of the assets of the partnership based on the fair market value of the net assets (total assets less total liabilities). The total assets of the partnership are $10 million in the accounting records, but the assets are worth at least $20 million. Because the firm’s total liabilities are $4 million, the attorney is asking for $5.3 million (one- third of $16 million). Strong and Hibbert do not agree, but all parties want to avoid a protracted, expensive lawsuit. They have decided to put the question to an arbitrator, who will make a determination of the settlement. Here are some other facts that may or may not be relevant. The current balances in the partners’ Capital accounts are $1.5 million for Tyler, $2.5 million for Strong, and $2.0 million for Hibbert. Net income in 20xx is to be distributed to the Capital accounts in the ratio of 1:4:3. Before Tyler’s semiretirement, the distribution ratio was 3:3:2. Assume you are the arbitrator; develop what you would consider a fair distribution of assets to Tyler’s estate. Defend your decision.

Internet Case LO1 Comparison of Career Opportunities in Partnerships and Corporations C 6. Accounting firms, which are among the world’s largest partnerships, provide a wide range of attractive careers for business and accounting majors. You can explore careers in public accounting by accessing the websites of one of the Big Four accounting firms: Deloitte & Touche, Ernst & Young, KPMG Inter- national, or PricewaterhouseCoopers. Each firm’s home page has a career opportunity section. Choose one of the Big Four firms and compile a list of facts about the firm—size, locations, services, and career opportunities. Do you have the interest and background for a career in public accounting? Why or why not? How do you think working for a large partnership would differ from or be Appendix B 11/9/06 4:31 PM Page B-45

Chapter Assignments | B-45 the same as working for a large corporation? Be prepared to discuss your findings in class.

Group Activity Case LO4 Partnership Agreement C 7. Form a partnership with one or two of your classmates. Assume that the two or three of you are forming a small service business. For example, you might form a company that hires college students to paint houses during the summer or to provide landscaping services. Working together, draft a partnership agreement for your business. The agreement can be a simple one, with just a sentence or two for each provision. However, it should include the name, location, and purpose of the business; the names of the partners and their respective duties; the investments of each partner; methods for distributing profits and losses; and procedures for deal- ing with the admission or withdrawal of partners, the withdrawal of assets, the death of a partner, and liquidation of the business. Include a title, date, and signature lines.

Business Communication Case LO4 Basic Research Skills C 8. Beginning employees are often asked to research topics and summarize the results for their bosses. Assume your boss wants you to find some information on the limited partnership. Use an Internet search engine, such as Google.com, to find the latest developments related to limited partnerships. Research at least two or three sources. Write a short summary of your findings, relating the content of the article to the content of this chapter or explaining the limited partnership form of business and how it is used today. Appendix B 11/20/06 10:39 AM Page B-46

B-46 | APPENDIX B Partnerships Endnotes

1. Ernst & Young, Annual Report, 2005. 5. Anita Raghavan, “Goldman Scrambles to Find $250 Million 2. Information excerpted from the 1990 and 2002 annual re- in Equity Capital from Private Investors,” The Wall Street Jour- ports of Alliance Capital Management Limited Partnership; nal, September 15, 1994. The Wall Street Journal, February 10, 2003. 6. “Nokia Unveils Plans for Chinese Centre,” Financial Times 3. Ernst & Young, “Our Ethics and Values,” www.ey.com, 2006. London, May 9, 2000. 4. Interpretation No. 46, Consolidation of Variable Interest Enti- ties” (Norwalk, Conn.: Financial Accounting Standards Board, December 2003).

Credits

Photo p. B-2, © James Leynse/Corbis; photo p. B-5, © Alan Klehr; photo p. B-7, © Jim West/The Image Works; logo p. B-7, Reprinted with permission of Ernst & Young.