CHAPTER 12
Partnerships
Chapter Overview
This chapter introduces the student to partnership accounting. The characteristics of the partnership—the partnership agreement, its limited life, mutual agency, unlimited liability, co-ownership of property, income taxes, and owners’ equity accounts (for the partners) are explained. General partnerships, limited partnerships, limited liability partnerships, and S corporations are defined. The chapter then describes how to account for the organization and start-up of a partnership and how to share (divide) partnership profits and losses. The partnership agreement should specify the method to be used; however, the text describes four methods that could be used. These methods are: sharing based on stated fraction, sharing based on partners’ capital contributions, sharing based on capital contributions and service to the partnership, and sharing based on salaries and interest on capital contributions. Partners’ drawings are discussed and illustrated.
The next section covers admission of a partner to the partnership and withdrawals of a partner from the partnership. The text illustrates how the new partner can buy an existing partner’s interest or invest additional capital in the partnership. In the latter case, the new partner may either receive a bonus from the existing partners or have to pay a bonus to the existing partners. The chapter then discusses withdrawal of a partner at the book value of the partner’s capital balance, at more than the book value of the partner’s capital balance, and at less than book value of the partner’s capital balance. Liquidation of a partnership is then explained. The text provides a three-step process for liquidating a partnership. Illustrations show assets sold at a gain and at a loss. Partnership financial statements are discussed. Decision guidelines provide answers to basic partnership questions. A summary problem reviews the admission of a new partner and the partnership balance sheet.
Learning
ObjectivesAfter studying Chapter 12, your students should be able to:
Chapter Outline
Objective 1: Identify the characteristics of a partnership
A. A partnership is an association of two or more partners who co-own a business usually with the intent to earn a profit. Exhibit 12-1 lists the eight largest accounting partnerships in the U.S.
B. The following are characteristics of a partnership:
1. The partnership agreement, or articles of partnership, may be written or oral. A written agreement is preferable, because it clarifies issues such as how profits and losses are to be shared.
2. A partnership’s life is limited to the time the partners continue to own the business.
a. Dissolution ends the partnership, although the business may continue under either the same name or a different one.
b. Admission or withdrawal of a partner dissolves the old partnership and creates a new one.
3. Mutual agency means that every partner may bind the partnership to contracts.
4. All partners have unlimited personal liability for partnership debts unless the partnership is a limited partnership. A limited partnership has one or more general partners who assume the general liability and the other partners are limited partners who only have limited liability, thus avoiding unlimited personal liability for partnership obligations.
5. All property contributed to, or purchased by, the partnership, is co-owned by all the partners.
6. The partnership itself does not pay income tax. Instead, each partner reports his share of the profit or loss on his personal tax return.
7. Accounting for a partnership is similar to accounting for a proprietorship. Each partner has an individual capital and withdrawal account.
8. Exhibit 12-2 lists the advantages and disadvantages of the partnership.
C. There are two basic types of partnerships.
1. The general partnership—each partner is an owner and has unlimited liability. Partnership income is reported to the IRS but each partner’s share of partnership income is taxed to the individual partner.
2. The limited partnership has at least one general partner who has unlimited liability and limited partners who have limited liability.
a. Many partnerships, such as accounting firms, organize as limited liability partnerships (LLP) where every partner has limited liability, but the LLP must maintain sufficient insurance to cover any liability.
b. S corporations are corporations that are taxed like partnerships. S Corporations can have no more than 75 stockholders, all of whom must be U.S. citizens.
Objective 2: Account for partners’ investments in a partnership
A. The initial investments made by the partners are recorded in the same way a proprietor’s contributions to the proprietorship are recorded. Exhibit 12-3 illustrates the partnership balance sheet.
B. Partners may invest assets and liabilities into the partnership.
1. Assets are recorded at current market value.
2. Any liabilities transferred to the partnership (assumed by the partnership) must be recorded, also at their current market value.
3. The difference between the market value of the assets and liabilities contributed to the partnership equals the credit to the partner’s individual capital account.
Objective 3: Allocate profits and losses to the partners
A. By law, the partners must share profits and losses equally unless there is some statement otherwise in the partnership agreement. Each partner’s share of the profits (losses) is added to (deducted from) his or her capital account.
B. Adding the partners’ shares of profits to their capital accounts does not involve cash.
C. Ways of sharing profits and losses include:
1. Share profits and losses based on a stated fraction for each partner.
2. Share profits and losses based on each partner’s capital contributions. A percentage of total capital contributed is calculated for each partner, and that percentage is applied to net income (loss) to determine the partner’s share.
3. Share profits and losses based on each partner’s capital contributions and service to the partnership.
a. Profits are first allocated based on the amount of capital contributed by each partner.
c. The remainder of the income is shared based on the profit- and loss-sharing ratio.
4. Share profits and losses based on a salary to each partner plus interest on each partner’s capital balance.
a. Profits are first allocated based on the amount of service; each partner in effect receives a salary allocation.
b. Next, interest (calculated based on beginning capital balances) is distributed to partners.
c. Any remaining net income or loss is divided based on the profit- and loss-sharing ratio.
D. Salary and interest allocated to partners are not expenses but merely ways to divide partnership profits and losses.
E. Drawings (withdrawals) are recorded in the drawing account of the partner who made the withdrawal.
1. Withdrawals are accumulated until the partners’ individual drawing accounts are closed into their individual capital accounts (at the end of the period during the closing process).
2. Partners are taxed on their share of net income (determined by one of the methods described above), not on the amount withdrawn from the partnership.
3. A partner’s withdrawals are not expenses, but merely transfers of cash or other assets to the partner.