Chapter 14: Partnerships - Formation and Operation



Chapter 9: Partnerships - Formation and Operation

I. Defined: a partnership is an association of two or more people or organizations formed to engage in some economic activity. Most accounting firms, legal firms, and many medical practices are partnerships.

II. Advantages:

A. Partners’ abilities: A partnership can take advantage of the abilities of many different individuals. For example, some partners might have special product or service development skills, while other partners might have marketing skills, while others might possess sufficient cash resources to allow the business to operate effectively.

B. Ease of formation: A partnership can be formed simply by two or more people or organizations agreeing to engage in some activity. There is no need to register with a state (as required of corporations) or to file with the Securities and Exchange Commission. There is no legal requirement for a written contract, although it is strongly recommended that a partnership agreement be prepared. A partnership agreement should be prepared in order to clarify the roles and responsibilities of the various partners and to specify how partnership income is to be allocated among the partners.

C. No partnership income taxes: Unlike corporations, which are separate taxable entities, partnerships do not pay income taxes. All income of the partnership is allocated to the partners and they are taxed on their share. Thus, the partnership is not taxed, but the partners are. The fact that corporations are taxed as separate entities and then the owners are taxed when they receive cash dividends usually makes the tax effect on corporation income greater than on partnership income.

III. Disadvantages:

A. Unlimited legal liability: Partnership law allows each partner to legally represent the partnership in business transactions (mutual agency). In addition, partnership law specifies that any partner can be held personally responsible for all debts of the partnership (unlimited liability). As a result, the major disadvantage of a partnership is that a partner could be held financially responsible for any other partner’s action on behalf of the partnership. Thus, even though a partner invested only $10,000 in a partnership, that partner could be legally responsible (at risk) for significantly more than the $10,000 if the partnership experiences severe financial difficulties. In contrast, if an individual invests $10,000 in a corporation, that individual is at risk for only $10,000, no matter how much financial difficulty the corporation experiences.

B. Obtaining resources: Due to the unlimited legal liability of partners, partnerships often find it much more difficult than corporations to raise large dollar amounts from investors.

IV. Owner’s Investments: Owners’ investments are important sources of partnership resources. Unlike corporation owners’ investments that are recorded in stockholders’ equity accounts, owners’ investments in partnerships are recorded in capital accounts. For example, assume that Chen and Khan form a partnership to provide internet art services. Chen is an internet expert and Khan has a significant amount of cash available from his previous business experience. To start the partnership, Chen invests $10,000 and Khan invests $40,000. The effects of their investments could be as follows.

|Date |Accounts |Debits |Credits |

| |Cash |50,000 | |

| |Chen, Capital | |10,000 |

| |Khan, Capital | |40,000 |

In the above example, each partner received credit for the dollar amount of cash he invested. Although it was necessary to increase cash by the $50,000 received by the partnership, the partners could have agreed to give a different amount of credit to each partner. For example, if the partners agreed to give equal credit to each partner, the effects would be as follows.

|Date |Accounts |Debits |Credits |

| |Cash |50,000 | |

| |Chen, Capital | |25,000 |

| |Khan, Capital | |25,000 |

It is important to note that partners may agree to treat each other in any way they desire, as long as the arrangement is legal.

If partners invest resources other than cash, such resources are usually recorded at their fair market value.

It is also important to note in the above examples that the accounting terminology for partnerships differs from that of corporations. Owners’ investments in partnerships are recorded in capital accounts, which are parts of a general classification called owners’ equity. Owners’ investments in corporations are recorded in contributed capital accounts, which are parts of a general classification called stockholders’ equity.

V. Withdrawals: Partners receive assets from a partnership by withdrawing them. Unlike corporations in which such distributions of assets to owners are usually recorded as dividends, asset withdrawals by partners are recorded in partner withdrawal accounts. For example, if Chen withdrew $500 and Khan withdrew $400 from their partnership, the effects would be as follows.

|Date |Accounts |Debits |Credits |

| |Chen, Drawing |500 | |

| |Khan, Drawing |400 | |

| |Cash | |900 |

Each partner’s drawing account is a contra owners’ equity account (similar to the dividends account in a corporation). At the end of each accounting period, each partner’s drawing account is closed to the partner’s capital account. For example, if Chen’s drawing account were closed to his capital account, the effects would be as follows.

|Date |Accounts |Debits |Credits |

| |Chen, Capital |500 | |

| |Chen, Drawing | |500 |

VI. Income Allocation: Similar to corporations, at the end of each accounting period, partnership revenues and expenses are closed to income summary. Unlike corporations, however, in which income summary is closed to retained earnings, partnership income summary is closed to individual partners’ accounts. This process of income allocation depends upon the requirements detailed in the partnership agreement. In the absence of a partnership agreement, partners share income equally. The allocation of partnership income often takes into consideration such things as investments, partner efforts, and special talents. For example, assume that the partnership agreement of Chen and Khan specifies that (1) each partner is to receive interest of 1% per month on his capital balance at the beginning of the month, (2) Chen is to receive a monthly salary of $6,000 and Khan is to receive $4,000, and (3) any remaining income is to be split equally between the partners. Assume that on April 1, 2006, Chen’s capital balance was $12,000 and Khan’s was $45,000. Assume also that the partnership’s income for April was $18,000. Based on this data, the partnership’s income would be distributed as shown below.

|Item |Chen |Khan |Totals |

|Interest | | | |

| $12,000 x .01 |$120 |$0 |$120 |

| $45,000 x .01 |$0 |$450 |$450 |

|Salary |$6,000 |$4,000 |$10,000 |

|Remaining income: $18,000 - $10,570 |$3,715 |$3,715 |$7,430 |

|Totals |$9,835 |$8,165 |$18,000 |

The above income allocation affects the partnership as follows.

|Date |Accounts |Debits |Credits |

| |Income Summary |18,000 | |

| |Chen, Capital | |9,835 |

| |Khan, Capital | |8,165 |

Assume that instead of $18,000, the partnership’s income for April was $9,000. Based on this data, the partnership’s income would be distributed as shown below.

|Item |Chen |Khan |Totals |

|Interest | | | |

| $12,000 x .01 |$120 |$0 |$120 |

| $45,000 x .01 |$0 |$450 |$450 |

|Salary |$6,000 |$4,000 |$10,000 |

|Remaining income: $9,000 - $10,570 |($785) |($785) |($1,570) |

|Totals |$5,335 |$3,665 |$9,000 |

The above income allocation affects the partnership as follows.

|Date |Accounts |Debits |Credits |

| |Income Summary |9,000 | |

| |Chen, Capital | |5,335 |

| |Khan, Capital | |3,665 |

Assume that instead of $18,000, the partnership’s income for April was a $1,000 loss. Based on this data, the partnership’s income would be distributed as shown below.

|Item |Chen |Khan |Totals |

|Interest | | | |

| $12,000 x .01 |$120 |$0 |$120 |

| $45,000 x .01 |$0 |$450 |$450 |

|Salary |$6,000 |$4,000 |$10,000 |

|Remaining income: - $1,000 - $10,570 |($5,785) |($5,785) |($11,570) |

|Totals |$335 |($1,335) |($1,000) |

The above income allocation affects the partnership as follows.

|Date |Accounts |Debits |Credits |

| |Khan, Capital |1,335 | |

| |Income Summary | |1,000 |

| |Chen, Capital | |335 |

VII. Dissolution: Technically, a partnership is dissolved whenever there is a change in partners. For example, the admission of another partner dissolves the old partnership and creates a new one. Similarly, when a partner leaves a partnership, the partnership is dissolved. Both these methods of dissolution are examined below.

A. Admission of a new partner: A new partner can be admitted to a partnership in two ways: (1) the purchase of an existing partner’s interest directly from the partner or (2) the investing of resources directly in the partnership.

1. Purchase of existing partner’s interest: When a new partner purchases an interest in a partnership by buying it directly from a current partner, the current partner’s capital interest is eliminated from the partnership’s accounting records and the new partner’s interest is recorded. In its simplest terms, the old partner’s capital interest is replaced by an equal dollar amount of capital interest of the new partner. For example, assume that Khan sells his $65,000 capital interest to Powell for $78,000. In this case, Khan receives $78,000 cash and Powell receives a $65,000 capital interest in the partnership. This method is called the book value method and the effects on the partnership would be as follows.

|Date |Accounts |Debits |Credits |

| |Khan, Capital |65,000 | |

| |Powell, Capital | |65,000 |

2. New partner investing resources directly in the partnership: When a new partner purchases an interest in a partnership by making payment directly to the partnership, the new partner’s capital interest is recorded. In its simplest terms, the new partner’s capital interest is recorded at that dollar amount equal to the new partner’s percentage interest in the partnership. For example, assume that Powell pays $30,000 to the Chen and Khan partnership for a 15% interest in the firm. Assume that immediately prior to the admission of Powell, the partners’ capital interests were as follows.

|Partner |Partner’s Capital |% |

|Chen |$35,000 |35% |

|Khan |$65,000 |65% |

|Totals |$100,000 |100% |

Powell’s $30,000 payment increases the partnership’s net assets to $130,000. Powell’s 15% capital interest would be $19,500 ($130,000 x .15). Since Powell paid $30,000 for a $19,500 interest in the partnership, the $10,500 excess payment ($30,000 - $19,500) would be allocated to the other partners according to their income sharing percentages. In this case, the capital balances of Chen and Khan would each increase by $5,250 ($10,500 / 2), since they share income equally. The effects on the partnership would be as follows.

|Date |Accounts |Debits |Credits |

| |Cash |30,000 | |

| |Chen, Capital | |5,250 |

| |Khan, Capital | |5,250 |

| |Powell, Capital | |19,500 |

After the admission of Powell, the partners’ capital interests would be as follows.

|Partner |Partner’s Capital |% |

|Chen |$40,250 |31% |

|Khan |$70,250 |54% |

|Powell |$19,500 |15% |

|Totals |$130,000 |100% |

B. Withdrawal of a partner: When a partner withdraws from a partnership, the partnership is dissolved according to the partnership agreement. If other partners remain in the partnership, a new partnership is formed.

Assume that Chen decides to withdraw from the partnership. Immediately prior to his withdrawal, the partners’ capital interests were as follows.

|Partner |Partner’s Capital |Income Sharing % |

|Chen |$60,000 |40% |

|Khan |$100,000 |40% |

|Powell |$50,000 |20% |

|Totals |$210,000 |100% |

If the partnership agreement requires an appraisal of the partnership’s value before a partner withdraws and such an appraisal indicates that the partnership’s value is $300,000, Chen would receive $96,000 when he withdraws. The $96,000 was calculated as follows.

|Item |Amount |

|Chen capital balance |$60,000 |

|Chen share of excess partnership value: ($300,000 - $210,000) x .40 |$36,000 |

|Total |$96,000 |

The payment of $96,000 cash to Chen upon his withdrawal results in him receiving $36,000 more than his capital interest in the partnership. A simple way to account for this difference is to reduce the other partners’ capital interests by a total of $36,000, according to their income sharing percentages. Since Khan’s income sharing percentage was 40%, and Powell’s was 20%, Khan’s capital balance would be reduced by $24,000 {$36,000 x [.40 / (.40 + .20)]} and Powell’s capital balance would be reduced by $12,000 {$36,000 x [.20 /(.40 + .20)]}. Chen’s withdrawal would affect the partnership as follows.

|Date |Accounts |Debits |Credits |

| |Chen, Capital |60,000 | |

| |Khan, Capital |24,000 | |

| |Powell, Capital |12,000 | |

| |Cash | |96,000 |

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