Lecture # 10

ACCOUNTING FOR PARTNERSHIPS

PARTNERSHIP CHARACTERISTICS

• Voluntary association

• Partnership Agreement

• Limited Life

• Mutual Agency

• Unlimited Liability

• Co-ownership of Partnership property

• Participation in partnership Income

Voluntary Association

• A voluntary association of individuals rather than a legal entity.

• A partner is responsible for his partner’s business actions under the law.

• A person must select a partner who shares his business objectives due to unlimited liability.

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Partnership Agreement

• Two or more competent people agree to be partners in some common business purpose.

• Partnership agreement does not have to be in written form.

• Good business practice calls for a written document providing details of partnership.

Partnership Agreement

• It should include name, location and purpose of business.

• Duties of partners• Investments of each partner.• Methods of distributing profits and losses ←

• The admission or withdrawal of partners.• Withdrawals of assets allowed for each

partner.• Procedure for dissolving or ending business.

LIMITED LIFE

• Partnership is dissolved when:• A partner withdraws• A partner goes bankrupt• A partner is incapacitated• A partner dies• A new partner is admitted• A partner retires• Partnership ends according to agreement.←

Participation in Partnership Income

• Partnership agreement should mention the method of distributing profit and losses to each partner.

• If an agreement doesn’t mention losses, they are distributed in the same way as profits.

• If agreement does not mention any method, then by law, they are shared equally.

ACCOUNTING FOR PARTNERS’ EQUITY

• separate Capital and Withdrawal accounts must be maintained for each partner.

• Balance of each partner’s capital is listed separately. • Total Liabilities $28,000• Partner’s Equity:• Desmond, capital $25,000• Frank, capital $34,000• Total Partners’ Equity $59,000• Total Liabilities & Equity $87,000

ACCOUNTING FOR PARTNERS’ EQUITY

• When assets other than cash are invested, partners must agree on their value.

• Value of non cash assets should be the fair market value on the date of transferring them to partnership.

• Value of assets must be entered into partnership agreement.

ACCOUNTING FOR PARTNERS’ EQUITY

• Jerry Adcock and Rose Villa agree to combine their capital and equipment into partnership for operating a jewelry store. Adcock will invest $28000 cash & $37000 of furniture and Villa will invest $40,000 cash & $20,000 equipment.

• What are the journal entries to record their initial investment??

ACCOUNTING FOR PARTNERS’ EQUITY

• July 1 Cash 28,000• Furniture 37,000• Adcock, Capital 65,000

• July 1 Cash 40,000• Equipment 20,000• Rose Villa, Capital 60,000

ACCOUNTING FOR PARTNERS’ EQUITY

• These values may differ from those carried on partners personal books.

• The equipment contributed by Villa was recorded on $12,000 in his personal book but at the time of investing it in business, market value increased. Then Villa’s investment must be recognized at the current market value of equipment.

• Partnership may also assume liabilities related to investments.

Distribution of Profit and losses

• Income of a partnership has three components:– Return to partners for the use of capital– Compensation for services provided– Further economic income for taking up business

risks.

Distribution of Profit and losses

• If partners contribute unequally, then income and losses should be shared according to:– Stated ratio– Capital Investment ratio– Salaries to partners and interest on partners

capital, with the remaining income shared according to stated ratio.

STATED RATIO

• Each partner must be given a stated ratio of the total income or losses.

• Adcock and Villa had a NI of $30,000 and agreement specified stated ratio of 60 and 40 respectively.

June 30 Income Summary $30,000 Adcock, capital $18,000 Villa, capital $12,000

Capital Investment Ratio

• If invested capital produced the most income for the business, then income and losses may be distributed according to capital investment.

• Two ways to distribute income and losses:1. Ratio of capital balance at the beginning of year2. Or to use average capital balance of each partner

during the year.

Capital Investment Ratio

• Adcock and villa capital accounts balances at the beginning of the year were as following:

• Adcock; 65,000 Villa: 60,000• NI = 140,000• Capital Capital ratio• Adcock 65000/125,000 = 52%• Villa 60,000/125,000 = 48%

Capital Investment Ratio

• Share of Income: • Adcock: 140,000 x 52% = $72,800• Villa: 140,000 x 48% = $67,200

June30 Income Summary 140,000 Adcock, Capital 72,800 Villa, Capital 67,200

Capital Investment Ratio

• If partners believe their capital balances will change during year, then average capital balances should be used to distribute income and losses.

• Assume that Adcock withdrew 10,000 on Jan1,19x2 and Villa withdrew 10,000 on Nov1,19x1 and invested an additional 8,000 on Feb1,19x2. Income for the year was $140,000.

Average capital BalancesPartner Date Capital x

BalanceMonths unchanged

Total Avg Capital

Adcock 7/x1-12/x1

65000 x 6 = 390,000

1/x2-6/x2 55,000 x 6 = 330,000

12 720,000/12

60,000

Villa 7/x1-10/x1

60,000 x 4 = 240,000

11/x1-1/x2 50,000 x 3 = 150,000

2/x2-6/x2 58,000 x 5 = 290,000

12 680,000/12

56,667

Average capital Balances

• Total Average Capital:• Adcock = 60,000 + Villa = 56,667 = 116,667

• Average Capital balance ratio;• Adcock = Adcock’s avg capital / Total avg capital• = 60,000 / 116,667 = 51.4%• Villa = Villa’s avg capital / Total avg capital• = 56,667 / 116,667 = 48.6%

• Distribution of Income:• Adcock: 140,000 x 51.4% = 71,960• Villa: 140,000 x 48.6% = 68,040

Income Summary 140,000 Adcock, Capital 71,960 Villa, Capital 68,040

Salaries, Interest, and Stated Ratio

• Salaries and interest on capital are not expenses, rather it is distribution of income among partners. They are not deducted as expenses before the income is determined.

• Assume Adcock’s salary is $8000 and Villa’s salary is $7000. Any remaining income will be divided equally.

Salaries, and Stated Ratio

Adcock Villa Total Income

Total income for distribution

140,000

Distribution of salaries

8000 7000 15,000

Remaining Income 125,000

Equal distribution of remaining income

62,500 62,500 125,000

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Income of Partners 70,500 69,500 140,000

Salaries, and Stated Ratio

Income Summary 140,000 Adcock, Capital 70,500

Villa, Capital 69,500 • Salaries and interest must be allocated to

partners even if income is not enough t cover these salaries and interest. Even in case of loss, these allocations must be made. The negative amount must be distributed among partners by stated ratio.

Salaries, Interest, and Stated Ratio

Adcock Villa Total Income

Total income for distribution

140,000

Distribution of salaries 70,000 60,000 130,000

Remaining Income 10,000

Distribution of Interest 6,500 6,000 12,500

(2,500)

Equal distribution of negative income

(1,250) (1,250) 2,500

Income of Partners 75,250 64,750 140,000