Chapter+13+Notes+-+Partnerships

Homework: SS1, SS2, SS3; BE13-2, BE13-3 Highlights: **partnership** is defined as two or more individuals (partners) in business to earn a profit; most partnerships are general partnerships (see below); each province has //Partnership Act// that defines basic rules for creation and operation of partnerships; most partnerships are formed by verbal or written agreement known as **partnership agreement** spelling out rights and responsibilities of each partner, but in absence of partnership agreement, provincial //Partnership Act// determines rights and responsibilities of partners; partnership is considered separate legal entity for certain purposes in that partnerships can own or dispose of property and sue or be sued in name of partnership; pursuant to business entity concept, assets and liabilities of partnership should be kept separate and distinct from assets and liabilities of individual partners; partnership profits and losses are typically divided among partners according to terms of partnership agreement; each partner's annual share of partnership net income (profit or loss) is taxable as personal income on his/her individual income tax return (Form T1), while annual drawings (actual asset withdrawals) of each partner do __not__ factor into calculation of taxable income (see below); according to concept of **mutual agency**, each partner is bound by decisions, even poor decisions, of other partners acting in furtherance of partnership affairs, unless those rights are limited in partnership agreement; partnership assets are owned jointly by all partners (regardless of initial contribution) and each partner has claim on total partnership assets equal to balance in his/her capital account; partnerships possess **limited life** as change in ownership structure (e.g., voluntary withdrawal of partner or death, incapacity, insolvency or mandatory retirement of partner) results in legal dissolution (termination) of partnership
 * __SO 1 - 2 - Partnerships__**

- unlike corporations, partnership structures generally do __not__ offer its owners limited liability with respect to the debts of the firm

- in a **general partnership** each and every partner possesses **unlimited liability** (jointly and severally) for any and all debts of the partnership, meaning __personal__ assets of any partner may be required to satisfy debts of partnership

- in a **limited partnership (LP)**, one or more partners possesses **unlimited liability** (general partner - see above) while one or more partners possesses **limited liability** (limited partner) such that his/her liability is limited to amount invested in business; limited partner enjoys limited liability in exchange for reduced compensation and/or less control over company affairs

- in a **limited liability partnership (LLP)** which is common among doctors, lawyers and accountants who are not permitted to incorporate in most jurisdictions, partners generally possess **unlimited liability** for debts of business but innocent partners are always protected from creditor claims resulting from negligence or misconduct of other partners

- in a **multidisciplinary practice (MDP)**, lawyers and other professionals such as accountants and engineers offer variety of services to public under one umbrella

(recently many professionals such as doctors and lawyers have begun to form **professional corporations** which offer some of the benefits of corporations including a modified form of limited liability)

- **advantages** of partnerships include combination of skills and resources of multiple individuals, ease and cost of formation, relative lack of government regulation and ease of decision-making

- **disadvantages** of partnerships include mutual agency, limited life and unlimited liability (see above)

- effective **partnership agreement** should be formal, written document (contract) containing name and address of firm, date of formation, names and initial capital contributions (investments) of partners, rights and responsibilities of partners, formula for calculating distribution of net income among partners, dispute resolution methods, procedures for addition or withdrawal of partner, rights and duties of remaining partners in event of partner withdrawal, etc.

- upon formation of partnership, **owner investments** should be recorded at current __fair market value__ (and __not__ net book value, i.e., cost minus accumulated depreciation) on date of transfer to partnership - accounts receivable should be recorded at updated __net realizable value__ (accounts receivable - allowance for doubtful accounts) as of date of partnership formation - please note that capital assets transferred into new partnership __cannot__ be recorded with accumulated depreciation account as no depreciation has accumulated as of first day of partnership, yet accounts receivable __can__ be recorded with updated allowance for doubtful accounts account as of first day of partnership representing current estimate of future uncollectible accounts

Cash - dr - 5,000 Automobile - dr - 2,000 (current fair market value) -- B. Gold, Capital - cr - 7,000
 * __Example of journalization of owner investments in new partnership (Gold and Silver, LLP) as of first day of operations:__**

Cash - dr - 12,000 Equipment - dr - 32,000 (current fair market value) -- R. Silver, Capital - cr - 44,000

- **partnership** **net income or net loss** is typically divided among partners according to formula known as **income ratio** (see SO 3 below) as specified in partnership agreement - in absence of partnership agreement or relevant clause in existing partnership agreement, partnership profits are divided evenly among partners (e.g., 50-50 in two-person partnership) pursuant to provincial //Partnership Act//

- distribution of partnership net income and closing of traditional temporary accounts (revenues, expenses, drawings) must be recorded at end of each period in form of **four closing entries** (R/E/I/D) using special temporary account called Income Summary

(1) Revenue - dr - 70,000 -- Income Summary - cr - 70,000
 * __Example of closing entries for Gold and Silver, LLP assuming $30,000 net income and 2:1 fixed ratio__**

(2) Income Summary - dr - 40,000 Advertising Expense - cr - 10,000 Rent Expense - cr - 30,000

(3) Income Summary - dr - 30,000 ($70,000 - $40,000) --- B. Gold, Capital - cr - 20,000 ($30,000 x 2/3) --- R. Silver, Capital - cr - 10,000 ($30,000 x 1/3)

(4) B. Gold, Capital - dr - 3,000 R. Silver, Capital - dr - 5,000 -- B. Gold, Drawings - cr - 3,000 -- R. Silver, Drawings - cr - 5,000

(closing entry #4 above assumes owner withdrawals throughout period are recorded as Drawings dr, Cash cr)

Homework: SS4, SS5, E13-3(a) Highlights: proper **partnership agreement** should include **income ratio** specifying precisely how net income will be distributed among partners
 * __SO 3 - 4 - SDNI__**

- income ratio typically allocates partnership net income via

(i) optional **fixed salaries to partners** (recognizing time contributed) (ii) optional **interest (fixed percentage) on beginning or ending partner capital balances** (recognizing capital invested) and (iii) mandatory **remaining/residual profit or loss allocated to partners according to fixed ratio** expressed either as proportion (3:1), percentage (75% and 25%) or fraction (3/4 and 1/4)

- note that when salary and interest exceed net income, residual loss is also shared according to fixed ratio - note also that salary allowances and interest on capital balances found in income ratio are for purposes of calculating partners' share of net income only and do not represent actual expenses paid by business

- partnership agreement may or may not limit each partner's actual cash withdrawals (drawings) to partner's salary allowance specified in income ratio - in any event, neither salary allowances nor actual cash withdrawals (drawings) are recorded as income on partner's individual income tax return (T1) as discussed above

- distribution of partnership income according to aforementioned income ratio is most often displayed using informal financial statement known as **Schedule of Division of Net Income** (see below and p. 613 of textbook) which is similar to grade 11's Statement of Distribution of Net Income or SDNI - alternatively, distribution of partnership net income may instead be disclosed in notes accompanying partnership income statement - once net income has been allocated to each partner according to income ratio regardless of method, closing entries may be journalized (see above)


 * __Schedule of Division of Net Income for Gold and Silver, LLP assuming $50,000 net income__**
 * //Fixed salaries to partners: Gold $10,000 --- Silver $15,000//**
 * //Interest (%) on year-end capital balances: Gold $4,000 (10% of $40,000) --- Silver $6,000 (20% of $30,000)//**
 * //Remaining income ($15,000) distributed in fixed ratio of 2:1: Gold $10,000 --- Silver $5,000//**


 * //Total income to partners: Gold $24,000 --- Silver $26,000//**

- formal **financial statements of partnerships** are very similar to those of sole proprietorship other than in terms of number of owners listed

(i) partnership **income statement** is essentially identical to that of sole proprietorship

(i) **schedule of division of net income** is u sed to divide partnership net income and is discussed above

(iii) not unlike statement of owner's equity for sole proprietorship, **statement of partners' equity** refers to equity equation for each individual partner: **beginning capital + owner investments + partner's share of net income - drawings = ending capital**

(iv) equity section of partnership **balance sheet** uses subheading "Partner's equity" rather than "Owner's equity" and contains ending capital balances for __ each __ individual partner as determined by statement of partners' equity

**__SO 5 - Admission of new partner__** Homework: SS7, SS8; BE13-8, BE13-9 Highlights: **admission of new partner to existing partnership** results in legal dissolution (termination) of old partnership and necessity to create new partnership and new partnership agreement containing updated income ratio, among other items - new capital account must also be created in the ledger for each new partner - new partner may be admitted either by (i) **private purchase of portion of capital interest of existing (old) partner(s)** or **(ii) investment of assets (typically money) in partnership, with or without bonus to existing partner(s) or new partner**

**(1) __private purchase__ of existing partner's capital interest:** admission of new partner by private purchase of portion of existing partner's capital interest __does not increase either total assets or total equity__ of partnership but does result in transfer of capital from existing partners to new partner - no cash is contributed to partnership itself in this transaction, but rather, money (purchase price) is exchanged privately between new and existing partners and becomes personal property of existing partners - essentially a private transaction between new and existing partners - from an accounting perspective, existing partners' capital accounts are decreased (dr) and new partner's capital account is increased (cr) by amount of negotiated purchase price - purchase price may or may not reflect actual capital interest acquired as funds are privately exchanged between parties - additionally, new income ratios (division of partnership profits) may not necessarily correspond to new capital interests, as income ratios are privately negotiated among the parties and recorded in new partnership agreement

X purchases **1/3 interest** in YZ Co. by private payment of **$15,000 each ($30,000 total)** to both Y and Z personally. Prior to admission, Y held capital of $30,000 and Z held capital of $30,000, so that total capital was $60,000. Y and Z agree to give up equal shares of their capital interests in exchange for this payment.
 * __ Example of admission of partner by private purchase of existing partner's capital interest __**

Y Capital - dr - 10,000 Z Capital - dr - 10,000 ..............X Capital - cr - 20,000 (1/3 of $60,000)

- net result of transaction: X, Y and Z now each hold $20,000 capital interest in new partnership, and there has been no change in total equity ($60,000) or total assets of partnership


 * - please note that regardless of the purchase price exchanged between the parties in the above example, the journal entry would remain the same given the private nature of the transaction **

**(2) investment of assets in partnership:** admission of new partner by investment of assets (typically money) in partnership __does increase both total assets and total equity__ of partnership - essentially a transaction between new partner and partnership itself - purchase price is exchanged between new partner and partnership so that purchase price becomes property of partnership and not individual partners - purchase price may or may not reflect actual capital interest acquired by new partner

**(a) investment of assets involving __no__ bonus:** when purchase price is __identical__ to capital interest acquired by new partner, no bonus accrues

X purchases **1/3 interest** in YZ Co. by payment of **$30,000** to YZ Co. Prior to admission, Y held capital of $30,000 and Z held capital of $30,000, so that total capital was $60,000.
 * __ Example of admission of partner by investment of assets with no bonus __**

Cash - dr - 30,000 ...........X Capital - cr - 30,000 (1/3 of $90,000 or $60,000 + $30,000)

- net result of transaction: X, Y and Z now each hold $30,000 capital interest in new partnership, and there has been an increase in both total equity (from $60,000 to $90,000) and total assets (Cash increased by $30,000) of partnership


 * (b)(i) i **** nvestment of assets involving bonus to __existing partners__: ** when purchase price is __greater__ than capital interest acquired by new partner, __ bonus __ (difference between investment and capital acquired) accrues to existing partners - existing partners may demand bonus from new partner as compensation for their past contributions to successful operation of partnership or in recognition of rising fair market value of company assets or unrecognized goodwill at time of admission - **bonus to existing partners takes the form of __increase__ in capital balances of existing partners and is typically divided among existing partners according to income ratio found in original partnership agreement**

X purchases **1/3 interest** in YZ Co. by payment of **$60,000** to YZ Co. Prior to admission, Y held capital of $30,000 and Z held capital of $30,000, so that total capital was $60,000. Income ratio of Y:Z is 1:1.
 * __ Example of admission of partner by investment of assets with bonus to existing partners __ **

Cash - dr - 60,000 ...........X Capital - cr - 40,000 (1/3 of $120,000 or $60,000 + $60,000) .......... Y Capital - cr - 10,000 (1/2 of $20,000 bonus to Y and Z) .......... Z Capital - cr - 10,000 (1/2 of $20,000 bonus to Y and Z)

- net result of transaction: X, Y and Z now each hold $40,000 capital interest in new partnership, and there has been an increase in both total equity (from $60,000 to $120,000) and total assets (Cash increased by $60,000) of partnership


 * (b)(ii) i****nvestment of assets involving bonus to __new partner__:** when purchase price is __less__ than capital interest acquired by new partner, __ bonus __ (difference between investment and capital acquired) accrues to new partner - new partner may demand bonus from existing partners as compensation for his/her anticipated contributions of expertise and/or resources to partnership or in recognition of falling fair market value of company assets at time of admission - **bonus to new partner takes the form of __decrease__ in capital balances of existing partners** **and is typically divided among existing partners** **according to income ratio found in original partnership agreement**

X purchases **1/2 interest** in YZ Co. by payment of **$30,000** to YZ Co. Prior to admission, Y held capital of $30,000 and Z held capital of $30,000, so that total capital was $60,000. Income ratio of Y:Z is 1:1.
 * __ Example of admission of partner by investment of assets with bonus to new partner __ **

Cash - dr - 30,000 Y Capital - dr - 7,500 (1/2 of $15,000 bonus to X) Z Capital - dr - 7,500 (1/2 of $15,000 bonus to X)  ............... X Capital - cr - 45,000 (1/2 of $90,000 or $60,000 + $30,000)

- net result of transaction: X now holds $45,000 capital interest while Y and Z now each hold $22,500 capital interest in new partnership, and there has been an increase in both total equity (from $60,000 to $90,000) and total assets (Cash increased by $30,000) of partnership

__ **SO 6 - Withdrawal of existing partner** __ Homework: SS9; BE13-10, BE13-11 Highlights: just as new partner may be admitted to existing partnership, **existing partner may withdraw (leave) partnership either voluntarily (by selling his/her equity in firm) or involuntarily (by forced removal, death, incapacity or bankruptcy)** - withdrawal of partner (like admission of new partner) legally dissolves partnership, thereby requiring creation of new partnership and partnership agreement - properly drafted partnership agreement should anticipate financial effects of withdrawal - like admission of new partner, withdrawal of existing partner may involve payment from partners' __personal__ assets or payment from __partnershi__p assets


 * (1) withdrawal by __private payment__ from partners' __personal__ assets**: withdrawal by payment from partners' personal assets is private transaction that __does not affect total assets or total equity__ of firm - essentially the reverse of admitting new partner who purchases existing partners' capital interest

X and Y each agree to pay $10,000 ($20,000 total) to Z in exchange for one half of Z's $16,000 total capital interest in XYZ Co.
 * __ Example of withdrawal of partner by private purchase of his/her capital interest __**

Z Capital - dr - 16,000 ...........X Capital - cr - 8,000 (1/2 of $16,000) ...........Y Capital - cr - 8,000 (1/2 of $16,000)

- net result of transaction: X and Y now each hold $8,000 more equity in new partnership than prior to withdrawal while Z no longer holds any equity in firm, but there has been no change in total assets or total equity of partnership


 * - please note that regardless of the purchase price exchanged between the parties in the above example, the journal entry would remain the same given the private nature of the transaction**


 * (2) withdrawal by payment from __partnership__ assets: ** withdrawal of existing partner by payment from assets (typically cash) of partnership __de__ __ creases both total assets and total equity __ of firm - essentially the reverse of admitting new partner who invests assets in firm - buyout payment may or may not reflect actual capital interest given up by departing partner

**(a) withdrawal involving payment from partnership assets with __no__ bonus:** when buyout payment is __identical__ to capital interest given up by departing partner, no bonus accrues to any party

XYZ Co. pays $16,000 cash from partnership assets in exchange for Z's total capital interest of $16,000 in firm
 * __ Example of withdrawal of partner by payment from partnership assets with no bonus __**

Z Capital - dr - 16,000 ..................Cash - cr - 16,000

- net result of transaction: Z no longer holds any capital interest in firm, and there has been a decrease in both total assets and total equity of partnership in the amount of $16,000


 * (b)(i) withdrawal** **involving payment from partnership assets with bonus to __departing partner__:** when buyout payment is __greater__ than capital interest relinquished by departing partner, __ bonus __ (difference between payment made and capital relinquished) accrues to departing partner - departing partner may demand bonus from remaining partners as compensation when fair market value of partnership assets (including goodwill) is greater than their net book value on date of withdrawal or when remaining partners seek to immediately remove partner from firm - **bonus to departing partner takes the form of __decrease__ in capital balances of remaining partners** **and decrease is typically divided among remaining partners** **according to income ratio found in original partnership agreement in relation to remaining partners only**

XYZ Co. pays $20,000 cash from partnership assets in exchange for Z's total capital interest of $16,000 in firm. Income ratio in XYZ Co. is 3:1:1.
 * __ Example of withdrawal of partner by payment from partnership assets with bonus to departing partner __ **

Z Capital - dr - 16,000 X Capital - dr - 3,000 (3/4 of $4,000 bonus to Z) Y Capital - dr - 1,000 (1/4 of $4,000 bonus to Z)  .....................................................Cash - cr - 20,000

- net result of transaction: X and Y now hold $3,000 and $1,000 less respectively in equity in new partnership than prior to withdrawal while Z no longer holds any equity in firm, and there has been a decrease in both total assets and total equity of partnership in the amount of $20,000


 * (b)(ii) withdrawal ** ** involving payment from partnership assets with bonus to __remaining partners__: ** when buyout payment is __less__ than capital interest relinquished by departing partner, __ bonus __ (difference between payment made and capital relinquished) accrues to remaining partners - remaining partners may demand bonus from departing partner as compensation when fair market value of partnership assets (including goodwill) is less than their net book value on date of withdrawal or when departing partner seeks to immediately leave firm - **bonus to remaining partners takes the form of __increase__ in capital balances of remaining partners** **and increase is typically divided among remaining partners** **according to income ratio found in original partnership agreement with respect to remaining partners only**

XYZ Co. pays $10,000 cash from partnership assets in exchange for Z's total capital interest of $16,000 in firm. Income ratio in XYZ Co. is 1:1:2.
 * __ Example of withdrawal of partner by payment from partnership assets with bonus to remaining partners __ **

Z Capital - dr - 16,000 ..............X Capital - cr - 3,000 (1/2 of $6,000 bonus to XYZ Co.) ..............Y Capital - cr - 3,000 (1/2 of $6,000 bonus to XYZ Co.) ..............Cash - cr - 10,000

- net result of transaction: X and Y now each hold $3,000 more equity in new partnership than prior to withdrawal while Z no longer holds any equity in firm, and there has been a decrease in both total assets and total equity of partnership in the amount of $16,000

__ **SO 7 - Liquidation of partnership assets** __ Homework: SS10; E13-10, E13-11 Highlights: whereas the **admission or withdrawal of a partner** brings about the **legal dissolution** of the partnership, the **liquidation of partnership assets** brings about the **financial/economic dissolution** of the partnership - liquidation involves the sale of all company assets, payment of all company liabilities and distribution of remaining proceeds to the partners - liquidation may result from **mutual agreement to wind down the company, commercial bankruptcy proceedings or the death, incapacity or bankruptcy of one or more of the partners**

- **sale of non-cash assets (supplies, equipment, land, etc.) for cash during liquidation is known as** **realization** - any difference between proceeds of sale (liquidation price) and net book value (cost minus accumulated depreciation) of said assets is referred to as **gain (or loss) on realization** and must be added or subtracted to partners' capital balances


 * - four steps are involved in liquidation of company assets:**


 * (1) realization of all non-cash partnership assets for cash **
 * (2) distribution of gain or loss on realization to partners pursuant to __income ratios__**
 * (3) payment of all partnership liabilities in cash**
 * (4) distribution of remaining cash to partners pursuant to __capital balan____ces__ - following this step, all account balances should have been closed to zero**

- **assume the following balances prior to liquidation: Cash $30,000, Equipment $20,000 (cost $30,000 minus Accumulated Depreciation $10,000), Accounts Payable $20,000, A Capital $15,000, B Capital $10,000, C Capital $5,000 - now assume the non-cash assets (Equipment @ $20,000 net) were liquidated (sold) for __$30,000__ cash **
 * __Example of liquidation of partnership assets in ABC Co. with 1:1:1 income ratio and no capital deficiency__**

(1) Cash - dr - 30,000 ..... Acc. Dep. on Equipment - dr - 10,000 ................................... Equipment - cr - 30,000 ................................... **Gain on realization - cr - 10,000**

(2) **Gain on realization - dr - 10,000** ................................A Capital - cr - 3,333 ............................... B Capital - cr - 3,333 ................................C Capital - cr - 3,333

(3) Accounts Payable - dr - 20,000 .....................................Cash - cr - 20,000


 * - no capital deficiency**: once partnership assets are liquidated and partnership liabilities are paid in full, all of the partners may find themselves with normal __credit__ balances in their capital accounts, a situation known as "no capital deficiency"

(4a) A Capital - dr - 18,333 ...... B Capital - dr - 13,333 ...... C Capital - dr - 8,333 ..................... Cash - cr - 40,000


 * __Example of liquidation of partnership assets in ABC Co. with 1:1:1 income ratio and capital deficiency__**
 * - assume the following balances prior to liquidation: Cash $30,000, Equipment $20,000 (cost $30,000 minus Accumulated Depreciation $10,000), Accounts Payable $20,000, A Capital $15,000, B Capital $10,000, C Capital $5,000 - now assume the non-cash assets (Equipment @ $20,000 net) were liquidated (sold) for __$2,000__ cash **

(1) Cash - dr - 2,000 ..... Acc. Dep. on Equip. - dr - 10,000 ..... **Loss on realization - dr - 18,000** ........................................Equipment - cr - 30,000

(2) A Capital - dr - 6,000 .....B Capital - dr - 6,000 .....C Capital - dr - 6,000 ................**Loss on realization - cr - 18,000**

(3) Accounts Payable - dr - 20,000 ...................................Cash - cr - 20,000


 * C now has a capital deficiency (debit balance) of $1,000**


 * - capital deficiency:** once partnership assets are liquidated and partnership liabilities are paid in full, one or more of the partners may find him/herself with an exceptional __debit__ balance in his/her capital account (likely the result of a loss on realization), a situation known as a "capital deficiency" - in such cases, partner with capital deficiency may or may not be able to pay the amount owing (debit balance) into the partnership


 * - payment of deficiency by C: assume C pays the amount owed into the partnership**

(4)(b)(i) Cash - dr - 1,000 ..................C Capital - cr - 1,000


 * - following payment by C, C now has a zero balance in his/her Capital account**

(4)(b)(ii) A Capital - dr - 9,000 ..............B Capital - dr - 4,000 .........................Cash - cr - 13,000


 * - nonpayment of deficiency by C: if we assume C does not pay the amount owed to the partnership, the other partners must absorb the loss pursuant to their __income ratios__**

(4)(c)(i) A Capital - dr - 500 .............B Capital - dr - 500 ......................C Capital - cr - 1,000


 * - following the absorption of the deficiency, C now has a zero balance in his/her Capital account**

(4)(b)(ii) A Capital - dr - 8,500 ............. B Capital - dr - 3,500 ......................... Cash - cr - 12,000