Dr. M. D. Chase Long Beach State University Advanced Accounting 1305-87B Partnership Accounting: Basic Concepts Page 1 PARTNERSHIP ACCOUNTING I. Basic Concepts of Partnership Accounting A. What is A Partnership?: An association of two or more persons to carry on as co-owners of a business for a profit; the basic rules of partnerships were defined by Congress: 1. Uniform Partnership Act of 1914 (general partnerships) 2. Uniform Limited Partnership Act of 1916 (limited partnerships) B. Characteristics of a Partnership: 1. Limited Life--dissolved by death, retirement, incapacity, bankruptcy etc 2. Mutual agency--partners are bound by each others’ acts 3. Unlimited Liability of the partners--the partnership is not a legal or taxable entity and therefore all debts and legal matters are the responsibility of the partners. 4. Co-ownership of partnership assets--all assets contributed to the partnership are owned by the individual partners in accordance with the terms of the partnership agreement; or equally if no agreement exists. C. The Partnership Agreement: A contract (oral or written) which can be used to modify the general partnership rules; partnership agreements at a minimum should cover the following: 1. Names or Partners and Partnership; 2. Effective date of the partnership contract and date of termination if applicable; 3. Nature of the business; 4. Place of business operations; 5. Amount of each partners capital and the valuation of each asset contributed and date the valuation was made; 6. Rights and responsibilities of each partner; 7. Dates of partnership accounting period; minimum capital investments for each partner and methods of determining equity balances (average, weighted average, year-end etc.) 8. A formula for the distribution of Net Income to each partner; 9. Rules regarding Drawing of Capital by partners; penalties violation of drawing agreements; 10. Procedures in the event of death, retirement or incapacity of partners; 11. Provision for arbitration of disputes 12. Rights and responsibilities upon dissolution and penalties for failing to comply; II. Partnership accounting Overview: A. Accounting for partnerships covers three primary areas: Note: Assets should be recorded at FMV at date of partnership organization because gains and losses on asset 1. Formation and operation of the partnership disposal will be partnership gains and losses and allocated 2. Changes in partnership equity subsequent to formation in accordance with the partnership agreement or profit 3. Partnership liquidations and loss ratio. Assets not recorded at FMV can result in inequities. To illustrate possible inequities created when III. FORMATION AND OPERATION OF THE PARTNERSHIP assets are not valued at FMV upon contribution to the firm, consider the following example: A. Opening the books: Assets (at FMV).................... xxxx Liabilities (book value)...... xxxx Capital....................... xxxx EXAMPLE: -- A & B form the AB partnership. -- "A" contributes land with a cost basis of $5,000 and a FMV of $10,000. -- "B" contributes cash of $10,000. -- The land is sold immediately for $10,000. Case #1: Land recorded at $5,000 Case #2: Land recorded at $10,000 "A" Capital "B" Capital "A" Capital "B" Capital Beginning Capital.... $ 5,000 $ 10,000 $ 10,000 $ 10,000 Gain on sale of land. 2,500 2,500 -0- -0- Ending Capital....... $ 7,500 $ 12,500 $ 10,000 $ 10,000 Dr. M. D. Chase Long Beach State University Advanced Accounting 1305-87B Partnership Accounting: Basic Concepts Page 2 B. Distribution of net income 1. net income may be distributed IAW with any method but the most common are: a. specified ratio (IAW partnership agreement) b. service contributed by partner c. relative investments 2. common factors often found in a partnership agreement regarding the distribution of partnership net income are: a. interest of capital (a reward for leaving capital in the partnership, not an expense) NOTE: SALARY IS SEPARATE FROM b. salary (a reward for services rendered to the partnership, not an expense) THE DRAWING ACCOUNT c. profit and loss ratio 1. anything agreed to by the partners 2. assumes that losses are shared in the same ratio as profits unless specified otherwise NOTE THAT INTEREST AND SALARIES ARE DISTRIBUTIONS OF NET INCOME AND NOT EXPENSES OF THE PARTNERSHIP EXAMPLE; 3. To illustrate the distribution of partnership income/loss IAW the partnership agreement, consider the following facts: -- A,B, and C form a partnership and at the end of the year have the following balances: A B C Beginning Capital........ $ 45,000 $ 34,000 $ 25,000 Drawing.................. 5,000 4,000 5,000 Ending Capital........... $ 40,000 $ 30,000 $ 20,000 The partnership agreement specifies the following: 1. Interest on EOY capital to be 7% 2. Salary 6k,8k,10k, respectively 3. profit and loss to be shared equally. REQUIRED: 1. What is the capital ratio at EOY? 2. Prepare a schedule reflecting the distribution of net income under each of the following independent assumptions: Assumption a. NI= $51,300 b. NI= $21,300 c. NI= $<4,500> d. NI= $0 3. Present the closing entry required on the partnership books at EOY to reflect the distribution of net income to the partners for case 2a above. Solution: 1. 4:3:2 2a. (NI=$51,300) A B C Total Interest on capital... $ 2,800 $ 2,100 $ 1,400 $ 6,300 Salary................ 6,000 8,000 10,000 24,000 Hypothetical distr.... 8,800 10,100 11,400 30,300 Excess IAW P/L ratio. 7,000 7,000 7,000 21,000 Actual distribution... $15,800 $17,100 $18,400 $51,300 2b. (NI=$21,300) Interest on capital... $ 2,800 $ 2,100 $ 1,400 $ 6,300 Salary................ 6,000 8,000 10,000 24,000 Hypothetical distr.... 8,800 10,100 11,400 30,300 Excess IAW P/L ratio .. <3,000> <3,000> <3,000> <9,000> Actual distribution... $ 5,800 $ 7,100 $ 8,400 $21,300 2c. (NI=$<4,500>) Interest on capital... $ 2,800 $ 2,100 $ 1,400 $ 6,300 Salary................ 6,000 8,000 10,000 24,000 Hypothetical distr.... 8,800 10,100 11,400 30,300 Excess IAW P/L ratio .<11,600> <11,600> <11,600> <34,800> Actual distribution... $<2,800> $<1,500> $< 200> $<4,500> Dr. M. D. Chase Long Beach State University Advanced Accounting 1305-87B Partnership Accounting: Basic Concepts Page 3 2d. (NI=$0) Interest on capital... $ 2,800 $ 2,100 $ 1,400 $ 6,300 Salary............... 6,000 8,000 10,000 24,000 Hypothetical distr.... 8,800 10,100 11,400 30,300 Excess IAW P/L ratio. <10,100> <10,100> <10,100> <30,300> Actual distribution... $<1,300> $ -0- $ 1,300 $ -0- 3. Income summary................ 51.300 "A" Capital.............. 15,800 "B" Capital.............. 17,100 "C" Capital.............. 18,400 C. Computation of Interest on Capital 1. You may be asked to compute interest on capital based on BOY, EOY or average capital balances. BOY and EOY are self explanatory, but the weighted average balance computation is more involved. Average Capital Balance = Net Capital Balance x time balance was unchanged = (Capital – Drawing) x time balance was unchanged This computation results in a weighted average. EXAMPLE: WTD "A" Capital: Date Change Balance Time AVG Note: For those of you studying for the CPA examination, 1/1 $10,000 1/12 $ 833 this is the same approach as computing weighted average 2/1 <100> 9,900 6/12 4,950 number of shares in an EPS problem 8/1 <500> 9,400 1/12 783 9/1 2,000 11,400 2/12 1,900 11/1 <200> 11,200 2/12 1,867 12/12 $ 10,333 D. Bonus to a Partner 1. A bonus is a means of rewarding a partner for meeting specified requirements. It is different than salary, but like salary it is not an expense. However, for computational purposes only, the partners may elect to treat the bonus as an expense i.e. the bonus will be computed based net income after bonus. Bonus is computed as follows: a. Bonus not treated as an expense: BONUS = BONUS % x PARTNERSHIP INCOME b. Bonus treated as an expense: BONUS = BONUS % (PARTNERSHIP INCOME - BONUS) EXAMPLE: --A and B are partners and agree that "A" is to receive a bonus of 20% of partnership income if the partnership has net income in excess of $40,000 per year. --The P/L ratio is 50:50 and NI=$50,000 this year. The distribution of net income would be as follows: a. Bonus not treated as an expense: A B Total Bonus to "A" 10,000 10,000 Balance IAW P/L ratio 20,000 20,000 40,000 Actual distribution 30,000 20,000 50,000 ** Let Bonus = X then X =.2(50,000 - X) = 10,000 - .2X b. Bonus treated as an expense: = 8,333 Bonus to "A" ** 8,333 8,333 Balance IAW P/L ratio 20,833 20,833 41,667 Actual distribution 29,167 20,833 50,000 Dr. M. D. Chase Long Beach State University Advanced Accounting 1305-87B Partnership Accounting: Basic Concepts Page 4 E. Changes in Partnership P/L Ratios During the Acct Period 1. When a partnership changes the P/L ratios, corrections of prior years income and distributions of non-operating gains and losses should be made using the P/L ratios in effect when the revenue was earned or the asset acquired. Example: The XY partnership acquired land at a cost of $100,000 when the P/L ratio was 60/40. The following year, the P/L ratio was changed to 70/30. At that time the FMV of the land was $140,000. The asset was sold for $200,000 later that year.