In 1990, Cliff Chenfield and Craig Balsam gave up the razors, ties, and six-figure salaries they had become accustomed to as New York lawyers. Instead, they set up a partnership, Razor & Tie Music, in Cliff's living room. Ten years later, it became the only record company in the country that had achieved success in selling music both on television and in stores. Razor & Tie's entertaining and effective TV commercials have yielded unprecedented sales for multi-artist music compilations. At the same time, its hot retail label has been behind some of the most recent original, progressive releases from artists such as Kelly Sweet, All That Remains, EndeverafteR, Angelique Kidjo, Ryan Shaw, Dave Barnes, Twisted Sister, Dar Williams, Danko Jones, and Yerba Buena.
Razor & Tie may be best known for its wildly popular Kidz Bop CD series, the top-selling children's audio product in the United States. Advertised on Nickelodeon, the Cartoon Network, and elsewhere, Kidz Bop titles have sold millions of copies. Many of its releases in the series have “gone Gold.”
Razor & Tie got its start with its first TV release, Those Fabulous '70s (100,000 copies sold), followed by Disco Fever (over 300,000 sold).
After restoring the respectability of the oft-maligned music of the 1970s, the partners forged into the musical '80s with the same zeal that elicited success with their first releases. In 1993, Razor & Tie released Totally '80s, a collection of Top-10 singles from the 1980s that has sold over 450,000 units. Featuring the tag line, “The greatest hits from the decade when communism died and music videos were born,” Totally '80s was the best-selling direct-response album in the country in 1993.
In 1995, Razor & Tie broke into the contemporary music world with Living in the '90s, the most successful record in the history of the company. Featuring a number of songs that were still hits on the radio at the time the package initially aired, Living in the '90s was a blockbuster. It received Gold certification in less than nine months and rewrote the rules on direct-response albums. For the first time, contemporary music was available through an album offered only through direct-response spots. Razor & Tie pursued that same strategy with its 2002 introduction of the Kidz Bop titles.
In fact, Razor & Tie is now a vertically integrated business that includes a music company with major label distribution, a music publishing business, a media buying company, a home video company, a direct marketing operation, and a growing database of entertainment consumers.
Razor & Tie has carved out a sizable piece of the market through the complementary talents of the two partners. Their imagination and savvy, along with exciting new releases planned for the coming years, ensure Razor & Tie's continued growth.
Preview of Chapter 12
It is not surprising that when Cliff Chenfield and Craig Balsam began Razor & Tie, they decided to use the partnership form of organization. Both saw the need for hands-on control of their product and its promotion. In this chapter, we discuss reasons why businesses select the partnership form of organization. We also explain the major issues in accounting for partnerships.
The content and organization of Chapter 12 are as follows.
A partnership is an association of two or more persons to carry on as co-owners of a business for profit. Partnerships are sometimes used in small retail, service, or manufacturing companies. Also accountants, lawyers, and doctors find it desirable to form partnerships with other professionals in the field.
Partnerships are fairly easy to form. People form partnerships simply by a verbal agreement or more formally by written agreement. We explain the principal characteristics of partnerships in the following sections.
A partnership is a legal entity. A partnership can own property (land, buildings, equipment) and can sue or be sued. A partnership also is an accounting entity. Thus, the personal assets, liabilities, and transactions of the partners are excluded from the accounting records of the partnership, just as they are in a proprietorship.
The net income of a partnership is not taxed as a separate entity. But, a partnership must file an information tax return showing partnership net income and each partner's share of that net income. Each partner's share is taxable at personal tax rates, regardless of the amount of net income each withdraws from the business during the year.
Mutual agency means that each partner acts on behalf of the partnership when engaging in partnership business. The act of any partner is binding on all other partners. This is true even when partners act beyond the scope of their authority, so long as the act appears to be appropriate for the partnership. For example, a partner of a grocery store who purchases a delivery truck creates a binding contract in the name of the partnership, even if the partnership agreement denies this authority. On the other hand, if a partner in a law firm purchased a snowmobile for the partnership, such an act would not be binding on the partnership. The purchase is clearly outside the scope of partnership business.
Corporations have unlimited life. Partnerships do not. A partnership may be ended voluntarily at any time through the acceptance of a new partner or the withdrawal of a partner. It may be ended involuntarily by the death or incapacity of a partner. Partnership dissolution occurs whenever a partner withdraws or a new partner is admitted. Dissolution does not necessarily mean that the business ends. If the continuing partners agree, operations can continue without interruption by forming a new partnership.
Each partner is personally and individually liable for all partnership liabilities. Creditors’ claims attach first to partnership assets. If these are insufficient, the claims then attach to the personal resources of any partner, irrespective of that partner's equity in the partnership. Because each partner is responsible for all the debts of the partnership, each partner is said to have unlimited liability.
Partners jointly own partnership assets. If the partnership is dissolved, each partner has a claim on total assets equal to the balance in his or her respective capital account. This claim does not attach to specific assets that an individual partner contributed to the firm. Similarly, if a partner invests a building in the partnership valued at $100,000 and the building is later sold at a gain of $20,000, the partners all share in the gain.
Partnership net income (or net loss) is also co-owned. If the partnership contract does not specify to the contrary, all net income or net loss is shared equally by the partners. As you will see later, though, partners may agree to unequal sharing of net income or net loss.
If you are starting a business with a friend and each of you has little capital and your business is not risky, you probably want to use a partnership. As indicated above, the partnership is easy to establish and its cost is minimal. These types of partnerships are often called regular partnerships. However if your business is risky—say, roof repair or performing some type of professional service—you will want to limit your liability and not use a regular partnership. As a result, special forms of business organizations with partnership characteristics are now often used to provide protection from unlimited liability for people who wish to work together in some activity.
The special partnership forms are limited partnerships, limited liability partnerships, and limited liability companies. These special forms use the same accounting procedures as those described for a regular partnership. In addition, for taxation purposes, all the profits and losses pass through these organizations (similar to the regular partnership) to the owners, who report their share of partnership net income or losses on their personal tax returns.
In a limited partnership, one or more partners have unlimited liability and one or more partners have limited liability for the debts of the firm. Those with unlimited liability are general partners. Those with limited liability are limited partners. Limited partners are responsible for the debts of the partnership up to the limit of their investment in the firm.
The words “Limited Partnership,” “Ltd.,” or “LP” identify this type of organization. For the privilege of limited liability, the limited partner usually accepts less compensation than a general partner and exercises less influence in the affairs of the firm. If the limited partners get involved in management, they risk their liability protection.
International Note
Much of the funding for successful new U.S. businesses comes from “venture capital” firms, which are organized as limited partnerships. To develop its own venture capital industry, China believes that it needs the limited liability form. Therefore, China has taken steps to model its partnership laws to allow for limited partnerships like those in the United States.
Most states allow professionals such as lawyers, doctors, and accountants to form a limited liability partnership or “LLP.” The LLP is designed to protect innocent partners from malpractice or negligence claims resulting from the acts of another partner. LLPs generally carry large insurance policies as protection against malpractice suits. These professional partnerships vary in size from a medical partnership of three to five doctors, to 150 to 200 partners in a large law firm, to more than 2,000 partners in an international accounting firm.
Helpful Hint In an LLP, all partners have limited liability. There are no general partners.
A hybrid form of business organization with certain features like a corporation and others like a limited partnership is the limited liability company or “LLC.” An LLC usually has a limited life. The owners, called members, have limited liability like owners of a corporation. Whereas limited partners do not actively participate in the management of a limited partnership (LP), the members of a limited liability company (LLC) can assume an active management role. For income tax purposes, the IRS usually classifies an LLC as a partnership.
ACCOUNTING ACROSS THE ORGANIZATION
Limited Liability Companies Gain in Popularity
The proprietorship form of business organization is still the most popular, followed by the corporate form. But whenever a group of individuals wants to form a partnership, the limited liability company is usually the popular choice.
One other form of business organization is a subchapter S corporation. A subchapter S corporation has many of the characteristics of a partnership—especially, taxation as a partnership—but it is losing its popularity. The reason: It involves more paperwork and expense than a limited liability company, which in most cases offers similar advantages.
Why do you think that the use of the limited liability company is gaining in popularity? (See page 605.)
Illustration 12-1 summarizes different forms of organizations that have partnership characteristics.
Source: www.nolo.com (accessed June 2010).
Why do people choose partnerships? One major advantage of a partnership is to combine the skills and resources of two or more individuals. In addition, partnerships are easily formed and are relatively free from government regulations and restrictions. A partnership does not have to contend with the “red tape” that a corporation must face. Also, partners generally can make decisions quickly on substantive business matters without having to consult a board of directors.
On the other hand, partnerships also have some major disadvantages. Unlimited liability is particularly troublesome. Many individuals fear they may lose not only their initial investment but also their personal assets, if those assets are needed to pay partnership creditors.
Illustration 12-2 summarizes the advantages and disadvantages of the regular partnership form of business organization. As indicated in the previous section, different types of partnership forms have evolved to reduce some of the disadvantages.
DO IT!
Partnership Organization
Indicate whether each of the following statements is true or false.
________ 1. | Partnerships have unlimited life. Corporations do not. |
________ 2. | Partners jointly own partnership assets. A partner's claim on partnership assets does not attach to specific assets. |
________ 3. | In a limited partnership, the general partners have unlimited liability. |
________ 4. | The members of a limited liability company have limited liability, like shareholders of a corporation, and they are taxed like corporate shareholders. |
________ 5. | Because of mutual agency, the act of any partner is binding on all other partners. |
Action Plan
When forming a business, carefully consider what type of organization would best suit the needs of the business.
Keep in mind the new, “hybrid” organizational forms that have many of the best characteristics of partnerships and corporations.
Solution
Related exercise material: E12-1 and DO IT! 12-1.
Ideally, the agreement of two or more individuals to form a partnership should be expressed in a written contract, called the partnership agreement or articles of co-partnership. The partnership agreement contains such basic information as the name and principal location of the firm, the purpose of the business, and date of inception. In addition, it should specify relationships among the partners, such as:
Ethics Note
A well-developed partnership agreement reduces ethical conflict among partners. It specifies in clear and concise language the process by which the partners will resolve ethical and legal problems. This issue is especially significant when the partnership experiences financial distress.
1. Names and capital contributions of partners.
2. Rights and duties of partners.
3. Basis for sharing net income or net loss.
4. Provision for withdrawals of assets.
5. Procedures for submitting disputes to arbitration.
6. Procedures for the withdrawal or addition of a partner.
7. Rights and duties of surviving partners in the event of a partner's death.
We cannot overemphasize the importance of a written contract. The agreement should attempt to anticipate all possible situations, contingencies, and disagreements. The help of a lawyer is highly desirable in preparing the agreement.
ACCOUNTING ACROSS THE ORGANIZATION
How to Part Ways Nicely
What should you do when you and your business partner do not agree on things, to the point where you are no longer on speaking terms? Given how heated business situations can get, this is not an unusual occurrence. Unfortunately, in many instances the partners do everything they can to undermine the other partner, eventually destroying the business. In some instances people even steal from the partnership because they either feel that they “deserve it” or they assume that the other partners are stealing from them.
It would be much better to follow the example of Jennifer Appel and her partner. They found that after opening a successful bakery and writing a cookbook, they couldn't agree on how the business should be run. The other partner bought out Ms. Appel's share of the business. Ms. Appel went on to start her own style of bakery, which she ultimately franchised.
Source: Paulette Thomas, “As Partnership Sours, Parting Is Sweet,” Wall Street Journal, (July 6, 2004), p. A20.
How can partnership conflicts be minimized and more easily resolved? (See page 605.)
We now turn to the basic accounting for partnerships. The major accounting issues relate to forming the partnership, dividing income or loss, and preparing financial statements.
Each partner's initial investment in a partnership is entered in the partnership records. The partnership should record these investments at the fair value of the assets at the date of their transfer to the partnership. All partners must agree to the values assigned.
To illustrate, assume that A. Rolfe and T. Shea combine their proprietorships to start a partnership named U.S. Software. The firm will specialize in developing financial modeling software packages. Rolfe and Shea have the following assets prior to the formation of the partnership.
Items under owners’ equity (OE) in the accounting equation analyses (in margins) are not labeled in this partnership chapter. Nearly all affect partners’ capital accounts.
The partnership records the investments as follows.
Note that the partnership records neither the original cost of the office equipment ($5,000) nor its book value ($5,000 – $2,000). It records the equipment at its fair value, $4,000. The partnership does not carry forward any accumulated depreciation from the books of previous entities (in this case, the two proprietorships).
In contrast, the gross claims on customers ($4,000) are carried forward to the partnership. The partnership adjusts the allowance for doubtful accounts to $1,000, to arrive at a cash (net) realizable value of $3,000. A partnership may start with an allowance for doubtful accounts because it will continue to collect existing accounts receivable, some of which are expected to be uncollectible. In addition, this procedure maintains the control and subsidiary relationship between Accounts Receivable and the accounts receivable subsidiary ledger.
After formation of the partnership, the accounting for transactions is similar to any other type of business organization. For example, the partners record all transactions with outside parties, such as the purchase or sale of inventory and the payment or receipt of cash, the same as would a sole proprietor.
The steps in the accounting cycle described in Chapter 4 for a proprietorship also apply to a partnership. For example, the partnership prepares a trial balance and journalizes and posts adjusting entries. A worksheet may be used. There are minor differences in journalizing and posting closing entries and in preparing financial statements, as we explain in the following sections. The differences occur because there is more than one owner.
Partners equally share partnership net income or net loss unless the partnership contract indicates otherwise. The same basis of division usually applies to both net income and net loss. It is customary to refer to this basis as the income ratio, the income and loss ratio, or the profit and loss (P&L) ratio. Because of its wide acceptance, we will use the term income ratio to identify the basis for dividing net income and net loss. The partnership recognizes a partner's share of net income or net loss in the accounts through closing entries.
As in the case of a proprietorship, a partnership must make four entries in preparing closing entries. The entries are:
1. Debit each revenue account for its balance, and credit Income Summary for total revenues.
2. Debit Income Summary for total expenses, and credit each expense account for its balance.
3. Debit Income Summary for its balance, and credit each partner's capital account for his or her share of net income. Or, credit Income Summary, and debit each partner's capital account for his or her share of net loss.
4. Debit each partner's capital account for the balance in that partner's drawing account, and credit each partner's drawing account for the same amount.
The first two entries are the same as in a proprietorship. The last two entries are different because (1) there are two or more owners’ capital and drawing accounts, and (2) it is necessary to divide net income (or net loss) among the partners.
To illustrate the last two closing entries, assume that AB Company has net income of $32,000 for 2014. The partners, L. Arbor and D. Barnett, share net income and net loss equally. Drawings for the year were Arbor $8,000 and Barnett $6,000. The last two closing entries are:
Assume that the beginning capital balance is $47,000 for Arbor and $36,000 for Barnett. After posting the closing entries, the capital and drawing accounts will appear as shown in Illustration 12-4.
As in a proprietorship, the partners’ capital accounts are permanent accounts. Their drawing accounts are temporary accounts. Normally, the capital accounts will have credit balances, and the drawing accounts will have debit balances. Drawing accounts are debited when partners withdraw cash or other assets from the partnership for personal use.
As noted earlier, the partnership agreement should specify the basis for sharing net income or net loss. The following are typical income ratios.
1. A fixed ratio, expressed as a proportion (6:4), a percentage (70% and 30%), or a fraction (2/3 and 1/3).
2. A ratio based either on capital balances at the beginning of the year or on average capital balances during the year.
3. Salaries to partners and the remainder on a fixed ratio.
4. Interest on partners’ capital balances and the remainder on a fixed ratio.
5. Salaries to partners, interest on partners’ capital, and the remainder on a fixed ratio.
The objective is to settle on a basis that will equitably reflect the partners’ capital investment and service to the partnership.
A fixed ratio is easy to apply, and it may be an equitable basis in some circumstances. Assume, for example, that Hughes and Lane are partners. Each contributes the same amount of capital, but Hughes expects to work full-time in the partnership and Lane expects to work only half-time. Accordingly, the partners agree to a fixed ratio of 2/3 to Hughes and 1/3 to Lane.
A ratio based on capital balances may be appropriate when the funds invested in the partnership are considered the critical factor. Capital ratios may also be equitable when the partners hire a manager to run the business and do not plan to take an active role in daily operations.
The three remaining ratios (items 3, 4, and 5) give specific recognition to differences among partners. These ratios provide salary allowances for time worked and interest allowances for capital invested. Then, the partnership allocates any remaining net income or net loss on a fixed ratio.
Salaries to partners and interest on partners’ capital are not expenses of the partnership. Therefore, these items do not enter into the matching of expenses with revenues and the determination of net income or net loss. For a partnership, as for other entities, salaries and wages expense pertains to the cost of services performed by employees. Likewise, interest expense relates to the cost of borrowing from creditors. But partners, as owners, are not considered either employees or creditors. When the partnership agreement permits the partners to make monthly withdrawals of cash based on their “salary,” the partnership debits these withdrawals to the partner's drawing account.
Under income ratio (5) in the list above, the partnership must apply salaries and interest before it allocates the remainder on the specified fixed ratio. This is true even if the provisions exceed net income. It is also true even if the partnership has suffered a net loss for the year. The partnership's income statement should show, below net income, detailed information concerning the division of net income or net loss.
To illustrate, assume that Sara King and Ray Lee are co-partners in the Kingslee Company. The partnership agreement provides for (1) salary allowances of $8,400 to King and $6,000 to Lee, (2) interest allowances of 10% on capital balances at the beginning of the year, and (3) the remaining income to be divided equally. Capital balances on January 1 were King $28,000, and Lee $24,000. In 2014, partnership net income is $22,000. The division of net income is as shown on page 576.
Kingslee records the division of net income as follows.
Now let's look at a situation in which the salary and interest allowances exceed net income. Assume that Kingslee Company's net income is only $18,000. In this case, the salary and interest allowances will create a deficiency of $1,600 ($18,000 – $19,600). The computations of the allowances are the same as those in the preceding example. Beginning with total salaries and interest, we complete the division of net income as shown in Illustration 12-6.
The financial statements of a partnership are similar to those of a proprietorship. The differences are due to the number of owners involved. The income statement for a partnership is identical to the income statement for a proprietorship except for the division of net income, as shown earlier.
The owners’ equity statement for a partnership is called the partners’ capital statement. It explains the changes in each partner's capital account and in total partnership capital during the year. Illustration 12-7 shows the partners’ capital statement for Kingslee Company. It is based on the division of $22,000 of net income in Illustration 12-5. The statement includes assumed data for the additional investment and drawings. The partnership prepares the partners’ capital statement from the income statement and the partners’ capital and drawing accounts.
Helpful Hint As in a proprietorship, partners’ capital may change due to (1) additional investment, (2) drawings, and (3) net income or net loss.
The balance sheet for a partnership is the same as for a proprietorship except for the owners’ equity section. For a partnership, the balance sheet shows the capital balances of each partner. The owners’ equity section for Kingslee Company would show the following.
DO IT!
Division of Net Income
LeeMay Company reports net income of $57,000. The partnership agreement provides for salaries of $15,000 to L. Lee and $12,000 to R. May. They will share the remainder on a 60:40 basis (60% to Lee). L. Lee asks your help to divide the net income between the partners and to prepare the closing entry.
Action Plan
Compute net income exclusive of any salaries to partners and interest on partners’ capital.
Deduct salaries to partners from net income.
Apply the partners’ income ratios to the remaining net income.
Prepare the closing entry distributing net income or net loss among the partners’ capital accounts.
Solution
Related exercise material: BE12-3, BE12-4, BE12-5, E12-4, E12-5, and DO IT! 12-2.
Liquidation of a business involves selling the assets of the firm, paying liabilities, and distributing any remaining assets. Liquidation may result from the sale of the business by mutual agreement of the partners, from the death of a partner, or from bankruptcy. Partnership liquidation ends both the legal and economic life of the entity.
From an accounting standpoint, the partnership should complete the accounting cycle for the final operating period prior to liquidation. This includes preparing adjusting entries and financial statements. It also involves preparing closing entries and a post-closing trial balance. Thus, only balance sheet accounts should be open as the liquidation process begins.
In liquidation, the sale of noncash assets for cash is called realization. Any difference between book value and the cash proceeds is called the gain or loss on realization. To liquidate a partnership, it is necessary to:
Ethics Note
The process of selling noncash assets and then distributing the cash reduces the likelihood of partner disputes. If, instead, the partnership distributes noncash assets to partners to liquidate the firm, the partners would need to agree on the value of the noncash assets, which can be very difficult to determine.
1. Sell noncash assets for cash and recognize a gain or loss on realization.
2. Allocate gain/loss on realization to the partners based on their income ratios.
3. Pay partnership liabilities in cash.
4. Distribute remaining cash to partners on the basis of their capital balances.
Each of the steps must be performed in sequence. The partnership must pay creditors before partners receive any cash distributions. Also, an accounting entry must record each step.
When a partnership is liquidated, all partners may have credit balances in their capital accounts. This situation is called no capital deficiency. Or, one or more partners may have a debit balance in the capital account. This situation is termed a capital deficiency. To illustrate each of these conditions, assume that Ace Company is liquidated when its ledger shows the following assets, liabilities, and owners’ equity accounts.
The partners of Ace Company agree to liquidate the partnership on the following terms. (1) The partnership will sell its noncash assets to Jackson Enterprises for $75,000 cash. (2) The partnership will pay its partnership liabilities. The income ratios of the partners are 3:2:1, respectively. The steps in the liquidation process are as follows.
1. Ace sells the noncash assets (accounts receivable, inventory, and equipment) for $75,000. The book value of these assets is $60,000 ($15,000 + $18,000 + $35,000 − $8,000). Thus, Ace realizes a gain of $15,000 on the sale. The entry is:
2. Ace allocates the $15,000 gain on realization to the partners based on their income ratios, which are 3:2:1. The entry is:
3. Partnership liabilities consist of Notes Payable $15,000 and Accounts Payable $16,000. Ace pays creditors in full by a cash payment of $31,000. The entry is:
4. Ace distributes the remaining cash to the partners on the basis of their capital balances. After posting the entries in the first three steps, all partnership accounts, including Gain on Realization, will have zero balances except for four accounts: Cash $49,000; R. Arnet, Capital $22,500; P. Carey, Capital $22,800; and W. Eaton, Capital $3,700, as shown below.
Ace records the distribution of cash as follows.
After posting this entry, all partnership accounts will have zero balances.
A word of caution: Partnerships should not distribute remaining cash to partners on the basis of their income-sharing ratios. On this basis, Arnet would receive three-sixths, or $24,500, which would produce an erroneous debit balance of $2,000. The income ratio is the proper basis for allocating net income or loss. It is not a proper basis for making the final distribution of cash to the partners.
The schedule of cash payments shows the distribution of cash to the partners in a partnership liquidation. A cash payments schedule is sometimes prepared to determine the distribution of cash to the partners in the liquidation of a partnership. The schedule of cash payments is organized around the basic accounting equation. Illustration 12-11 shows the schedule for Ace Company. The numbers in parentheses refer to the four required steps in the liquidation of a partnership. They also identify the accounting entries that Ace must make. The cash payments schedule is especially useful when the liquidation process extends over a period of time.
Alternative Terminology
The schedule of cash payments is sometimes called a safe cash payments schedule.
DO IT!
Partnership Liquidation—No Capital Deficiency
The partners of Grafton Company have decided to liquidate their business. Noncash assets were sold for $115,000. The income ratios of the partners Kale D., Croix D., and Marais K. are 2:3:3, respectively. Complete the following schedule of cash payments for Grafton Company.
First, sell the noncash assets and determine the gain.
Allocate the gain to the partners based on their income ratios.
Use cash to pay off liabilities.
Distribute remaining cash on the basis of their capital balances.
Solution
Related exercise material: BE12-6, E12-8, E12-9, and DO IT! 12-3.
A capital deficiency may result from recurring net losses, excessive drawings, or losses from realization suffered during liquidation. To illustrate, assume that Ace Company is on the brink of bankruptcy. The partners decide to liquidate by having a “going-out-of-business” sale. They sell merchandise at substantial discounts, and sell the equipment at auction. Cash proceeds from these sales and collections from customers total only $42,000. Thus, the loss from liquidation is $18,000 ($60,000 − $42,000). The steps in the liquidation process are as follows.
1. The entry for the realization of noncash assets is:
2. Ace allocates the loss on realization to the partners on the basis of their income ratios. The entry is:
3. Ace pays the partnership liabilities. This entry is the same as the previous one.
4. After posting the three entries, two accounts will have debit balances—Cash $16,000, and W. Eaton, Capital $1,800. Two accounts will have credit balances—R. Arnet, Capital $6,000, and P. Carey, Capital $11,800. All four accounts are shown below.
Eaton has a capital deficiency of $1,800 and so owes the partnership $1,800. Arnet and Carey have a legally enforceable claim for that amount against Eaton's personal assets. Note that the distribution of cash is still made on the basis of capital balances. But, the amount will vary depending on how Eaton settles the deficiency. Two alternatives are presented in the following sections.
If the partner with the capital deficiency pays the amount owed the partnership, the deficiency is eliminated. To illustrate, assume that Eaton pays $1,800 to the partnership. The entry is:
After posting this entry, account balances are as follows.
The cash balance of $17,800 is now equal to the credit balances in the capital accounts (Arnet $6,000 + Carey $11,800). Ace now distributes cash on the basis of these balances. The entry is:
After posting this entry, all accounts will have zero balances.
If a partner with a capital deficiency is unable to pay the amount owed to the partnership, the partners with credit balances must absorb the loss. The partnership allocates the loss on the basis of the income ratios that exist between the partners with credit balances.
The income ratios of Arnet and Carey are 3:2, or 3/5 and 2/5, respectively. Thus, Ace would make the following entry to remove Eaton's capital deficiency.
After posting this entry, the cash and capital accounts will have the following balances.
The cash balance ($16,000) now equals the sum of the credit balances in the capital accounts (Arnet $4,920 + Carey $11,080). Ace records the distribution of cash as:
After posting this entry, all accounts will have zero balances.
DO IT!
Partnership Liquidation—Capital Deficiency
Kessington Company wishes to liquidate the firm by distributing the company's cash to the three partners. Prior to the distribution of cash, the company's balances are Cash $45,000; Rollings, Capital (Cr.) $28,000; Havens, Capital (Dr.) $12,000; and Ostergard, Capital (Cr.) $29,000. The income ratios of the three partners are 4:4:2, respectively. Prepare the entry to record the absorption of Havens’ capital deficiency by the other partners and the distribution of cash to the partners with credit balances.
Allocate any unpaid capital deficiency to the partners with credit balances, based on their income ratios.
After distribution of the deficiency, distribute cash to the remaining partners, based on their capital balances.
Solution
Related exercise material: E12-10 and DO IT! 12-4.
On January 1, 2014, the capital balances in Hollingsworth Company are Lois Holly $26,000, and Jim Worth $24,000. In 2014 the partnership reports net income of $30,000. The income ratio provides for salary allowances of $12,000 for Holly and $10,000 to Worth and the remainder equally. Neither partner had any drawings in 2014.
Instructions
(a) Prepare a schedule showing the distribution of net income in 2014.
(b) Journalize the division of 2014 net income to the partners.
Solution to Comprehensive DO IT!
Action Plan
Compute the net income of the partnership.
Allocate the partners’ salaries.
Divide the remaining net income among the partners, applying the income/loss ratio.
Journalize the division of net income in a closing entry.
1 Identify the characteristics of the partnership form of business organization. The principal characteristics of a partnership are (a) association of individuals, (b) mutual agency, (c) limited life, (d) unlimited liability, and (e) co-ownership of property.
2 Explain the accounting entries for the formation of a partnership. When formed, a partnership records each partner's initial investment at the fair value of the assets at the date of their transfer to the partnership.
3 Identify the bases for dividing net income or net loss. Partnerships divide net income or net loss on the basis of the income ratio, which may be (a) a fixed ratio, (b) a ratio based on beginning or average capital balances, (c) salaries to partners and the remainder on a fixed ratio, (d) interest on partners’ capital and the remainder on a fixed ratio, and (e) salaries to partners, interest on partners’ capital, and the remainder on a fixed ratio.
4 Describe the form and content of partnership financial statements. The financial statements of a partnership are similar to those of a proprietorship. The principal differences are as follows. (a) The partnership shows the division of net income on the income statement. (b) The owners’ equity statement is called a partners’ capital statement. (c) The partnership reports each partner's capital on the balance sheet.
5 Explain the effects of the entries to record the liquidation of a partnership. When a partnership is liquidated, it is necessary to record the (a) sale of noncash assets, (b) allocation of the gain or loss on realization, (c) payment of partnership liabilities, and (d) distribution of cash to the partners on the basis of their capital balances.
Capital deficiency A debit balance in a partner's capital account after allocation of gain or loss. (p. 578).
General partners Partners who have unlimited liability for the debts of the firm. (p. 569).
Income ratio The basis for dividing net income and net loss in a partnership. (p. 574).
Limited liability company A form of business organization, usually classified as a partnership for tax purposes and usually with limited life, in which partners, who are called members, have limited liability. (p. 569).
Limited liability partnership A partnership of professionals in which partners are given limited liability and the public is protected from malpractice by insurance carried by the partnership. (p. 569).
Limited partners Partners whose liability for the debts of the firm is limited to their investment in the firm. (p. 569).
Limited partnership A partnership in which one or more general partners have unlimited liability and one or more partners have limited liability for the obligations of the firm. (p. 569).
No capital deficiency All partners have credit balances after allocation of gain or loss. (p. 578).
Partners’ capital statement The owners’ equity statement for a partnership which shows the changes in each partner's capital account and in total partnership capital during the year. (p. 576).
Partnership An association of two or more persons to carry on as co-owners of a business for profit. (p. 568).
Partnership agreement A written contract expressing the voluntary agreement of two or more individuals in a partnership. (p. 571).
Partnership dissolution A change in partners due to withdrawal or admission, which does not necessarily terminate the business. (p. 568).
Partnership liquidation An event that ends both the legal and economic life of a partnership. (p. 578).
Schedule of cash payments A schedule showing the distribution of cash to the partners in a partnership liquidation. (p. 580).
The chapter explained how the basic accounting for a partnership works. We now look at how to account for a common occurrence in partnerships—the addition or withdrawal of a partner.
The admission of a new partner results in the legal dissolution of the existing partnership and the beginning of a new one. From an economic standpoint, however, the admission of a new partner (or partners) may be of minor significance in the continuity of the business. For example, in large public accounting or law firms, partners are admitted annually without any change in operating policies. To recognize the economic effects, it is necessary only to open a capital account for each new partner. In the entries illustrated in this appendix, we assume that the accounting records of the predecessor firm will continue to be used by the new partnership.
LEARNING OBJECTIVE 6
Explain the effects of the entries when a new partner is admitted.
A new partner may be admitted either by (1) purchasing the interest of one or more existing partners or (2) investing assets in the partnership. The former affects only the capital accounts of the partners who are parties to the transaction. The latter increases both net assets and total capital of the partnership.
Helpful Hint In a purchase of an interest, the partnership is not a participant in the transaction. In this transaction, the new partner contributes no cash to the partnership.
The admission of a partner by purchase of an interest is a personal transaction between one or more existing partners and the new partner. Each party acts as an individual separate from the partnership entity. The individuals involved negotiate the price paid. It may be equal to or different from the capital equity acquired. The purchase price passes directly from the new partner to the partners who are giving up part or all of their ownership claims.
Any money or other consideration exchanged is the personal property of the participants and not the property of the partnership. Upon purchase of an interest, the new partner acquires each selling partner's capital interest and income ratio.
Accounting for the purchase of an interest is straightforward. The partnership records only the changes in partners’ capital. Partners’ capital accounts are debited for any ownership claims sold. At the same time, the new partner's capital account is credited for the capital equity purchased. Total assets, total liabilities, and total capital remain unchanged, as do all individual asset and liability accounts.
To illustrate, assume that L. Carson agrees to pay $10,000 each to C. Ames and D. Barker for 33⅓% (one-third) of their interest in the Ames–Barker partnership. At the time of the admission of Carson, each partner has a $30,000 capital balance. Both partners, therefore, give up $10,000 of their capital equity. The entry to record the admission of Carson is:
The effect of this transaction on net assets and partners’ capital is shown below.
Note that net assets remain unchanged at $60,000, and each partner has a $20,000 capital balance. Ames and Barker continue as partners in the firm, but the capital interest of each has changed. The cash paid by Carson goes directly to the individual partners and not to the partnership.
Regardless of the amount paid by Carson for the one-third interest, the entry is exactly the same. If Carson pays $12,000 each to Ames and Barker for one-third of the partnership, the partnership still makes the entry shown above.
The admission of a partner by an investment of assets is a transaction between the new partner and the partnership. Often referred to simply as admission by investment, the transaction increases both the net assets and total capital of the partnership.
Assume, for example, that instead of purchasing an interest, Carson invests $30,000 in cash in the Ames-Barker partnership for a 33⅓% capital interest. In such a case, the entry is:
The effects of this transaction on the partnership accounts would be:
Note that both net assets and total capital have increased by $30,000.
Remember that Carson's one-third capital interest might not result in a one-third income ratio. The new partnership agreement should specify Carson's income ratio, and it may or may not be equal to the one-third capital interest.
The comparison of the net assets and capital balances in Illustration 12A-3 shows the different effects of the purchase of an interest and admission by investment.
When a new partner purchases an interest, the total net assets and total capital of the partnership do not change. When a partner is admitted by investment, both the total net assets and the total capital change.
In the case of admission by investment, further complications occur when the new partner's investment differs from the capital equity acquired. When those amounts are not the same, the difference is considered a bonus either to (1) the existing (old) partners or (2) the new partner.
BONUS TO OLD PARTNERS For both personal and business reasons, the existing partners may be unwilling to admit a new partner without receiving a bonus. In an established firm, existing partners may insist on a bonus as compensation for the work they have put into the company over the years. Two accounting factors underlie the business reason. First, total partners’ capital equals the book value of the recorded net assets of the partnership. When the new partner is admitted, the fair values of assets such as land and buildings may be higher than their book values. The bonus will help make up the difference between fair value and book value. Second, when the partnership has been profitable, goodwill may exist. But, the partnership balance sheet does not report goodwill. The new partner is usually willing to pay the bonus to become a partner.
A bonus to old partners results when the new partner's investment in the firm is greater than the capital credit on the date of admittance. The bonus results in an increase in the capital balances of the old partners. The partnership allocates the bonus to them on the basis of their income ratios before the admission of the new partner. To illustrate, assume that the Bart-Cohen partnership, owned by Sam Bart and Tom Cohen, has total capital of $120,000. Lea Eden acquires a 25% ownership (capital) interest in the partnership by making a cash investment of $80,000. The procedure for determining Eden's capital credit and the bonus to the old partners is as follows.
1. Determine the total capital of the new partnership. Add the new partner's investment to the total capital of the old partnership. In this case, the total capital of the new firm is $200,000, computed as follows.
2. Determine the new partner's capital credit. Multiply the total capital of the new partnership by the new partner's ownership interest. Eden's capital credit is $50,000 ($200,000 × 25%).
3. Determine the amount of bonus. Subtract the new partner's capital credit from the new partner's investment. The bonus in this case is $30,000 ($80,000 − $50,000).
4. Allocate the bonus to the old partners on the basis of their income ratios. Assuming the ratios are Bart 60%, and Cohen 40%, the allocation is Bart $18,000 ($30,000 × 60%) and Cohen $12,000 ($30,000 × 40%).
The entry to record the admission of Eden is:
BONUS TO NEW PARTNER A bonus to a new partner results when the new partner's investment in the firm is less than his or her capital credit. This may occur when the new partner possesses special attributes that the partnership wants. For example, the new partner may be able to supply cash that the firm needs for expansion or to meet maturing debts. Or the new partner may be a recognized expert in a relevant field. Thus, an engineering firm may be willing to give a renowned engineer a bonus to join the firm. The partners of a restaurant may offer a bonus to a sports celebrity in order to add the athlete's name to the partnership. A bonus to a new partner may also result when recorded book values on the partnership books are higher than their fair values.
A bonus to a new partner results in a decrease in the capital balances of the old partners. The amount of the decrease for each partner is based on the income ratios before the admission of the new partner. To illustrate, assume that Lea Eden invests $20,000 in cash for a 25% ownership interest in the Bart–Cohen partnership. The computations for Eden's capital credit and the bonus are as follows, using the four procedures described in the preceding section.
The partnership records the admission of Eden as follows.
Now let's look at the opposite situation–the withdrawal of a partner. A partner may withdraw from a partnership voluntarily, by selling his or her equity in the firm. Or, he or she may withdraw involuntarily, by reaching mandatory retirement age or by dying. The withdrawal of a partner, like the admission of a partner, legally dissolves the partnership. The legal effects may be recognized by dissolving the firm. However, it is customary to record only the economic effects of the partner's withdrawal, while the firm continues to operate and reorganizes itself legally.
LEARNING OBJECTIVE 7
Describe the effects of the entries when a partner withdraws from the firm.
As indicated earlier, the partnership agreement should specify the terms of withdrawal. The withdrawal of a partner may be accomplished by (1) payment from partners’ personal assets or (2) payment from partnership assets. The former affects only the partners’ capital accounts. The latter decreases total net assets and total capital of the partnership.
Withdrawal by payment from partners’ personal assets is a personal transaction between the partners. It is the direct opposite of admitting a new partner who purchases a partner's interest. The remaining partners pay the retiring partner directly from their personal assets. Partnership assets are not involved in any way, and total capital does not change. The effect on the partnership is limited to changes in the partners’ capital balances.
To illustrate, assume that partners Morz, Nead, and Odom have capital balances of $25,000, $15,000, and $10,000, respectively. Morz and Nead agree to buy out Odom's interest. Each of them agrees to pay Odom $8,000 in exchange for one-half of Odom's total interest of $10,000. The entry to record the withdrawal is:
The effect of this entry on the partnership accounts is shown below.
Note that net assets and total capital remain the same at $50,000.
What about the $16,000 paid to Odom? You've probably noted that it is not recorded. The entry debited Odom's capital only for $10,000, not for the $16,000 that she received. Similarly, both Morz and Nead credit their capital accounts for only $5,000, not for the $8,000 they each paid.
After Odom's withdrawal, Morz and Nead will share net income or net loss equally unless they indicate another income ratio in the partnership agreement.
Withdrawal by payment from partnership assets is a transaction that involves the partnership. Both partnership net assets and total capital decrease as a result. Using partnership assets to pay for a withdrawing partner's interest is the reverse of admitting a partner through the investment of assets in the partnership.
Many partnership agreements provide that the amount paid should be based on the fair value of the assets at the time of the partner's withdrawal. When this basis is required, some maintain that any differences between recorded asset balances and their fair values should be (1) recorded by an adjusting entry, and (2) allocated to all partners on the basis of their income ratios. This position has serious flaws. Recording the revaluations violates the historical cost principle, which requires that assets be stated at original cost. It also violates the going-concern assumption, which assumes the entity will continue indefinitely. The terms of the partnership contract should not dictate the accounting for this event.
In accounting for a withdrawal by payment from partnership assets, the partnership should not record asset revaluations. Instead, it should consider any difference between the amount paid and the withdrawing partner's capital balance as a bonus to the retiring partner or to the remaining partners.
BONUS TO RETIRING PARTNER A partnership may pay a bonus to a retiring partner when:
1. The fair value of partnership assets is more than their book value,
2. There is unrecorded goodwill resulting from the partnership's superior earnings record, or
3. The remaining partners are eager to remove the partner from the firm.
The partnership deducts the bonus from the remaining partners’ capital balances on the basis of their income ratios at the time of the withdrawal.
To illustrate, assume that the following capital balances exist in the RST partnership: Roman $50,000, Sand $30,000, and Terk $20,000. The partners share income in the ratio of 3:2:1, respectively. Terk retires from the partnership and receives a cash payment of $25,000 from the firm. The procedure for determining the bonus to the retiring partner and the allocation of the bonus to the remaining partners is as follows.
1. Determine the amount of the bonus. Subtract the retiring partner's capital balance from the cash paid by the partnership. The bonus in this case is $5,000 ($25,000 − $20,000).
2. Allocate the bonus to the remaining partners on the basis of their income ratios. The ratios of Roman and Sand are 3:2. Thus, the allocation of the $5,000 bonus is: Roman $3,000 ($5,000 × 3/5) and Sand $2,000 ($5,000 × 2/5).
Helpful Hint Compare this entry to the one on page 591.
The partnership records the withdrawal of Terk as follows.
The remaining partners, Roman and Sand, will recover the bonus given to Terk as the partnership sells or uses the undervalued assets.
BONUS TO REMAINING PARTNERS The retiring partner may give a bonus to the remaining partners when:
1. Recorded assets are overvalued,
2. The partnership has a poor earnings record, or
3. The partner is eager to leave the partnership.
In such cases, the cash paid to the retiring partner will be less than the retiring partner's capital balance. The partnership allocates (credits) the bonus to the capital accounts of the remaining partners on the basis of their income ratios.
To illustrate, assume instead that the partnership pays Terk only $16,000 for her $20,000 equity when she withdraws from the partnership. In that case:
1. The bonus to remaining partners is $4,000 ($20,000 − $16,000).
2. The allocation of the $4,000 bonus is: Roman $2,400 ($4,000 × 3/5) and Sand $1,600 ($4,000 × 2/5).
Helpful Hint Compare this entry to the one on page 590.
Under these circumstances, the entry to record the withdrawal is:
Note that if Sand had withdrawn from the partnership, Roman and Terk would divide any bonus on the basis of their income ratio, which is 3:1 or 75% and 25%.
The death of a partner dissolves the partnership. However, partnership agreements usually contain a provision for the surviving partners to continue operations. When a partner dies, it usually is necessary to determine the partner's equity at the date of death. This is done by (1) determining the net income or loss for the year to date, (2) closing the books, and (3) preparing financial statements. The partnership agreement may also require an independent audit and a revaluation of assets.
The surviving partners may agree to purchase the deceased partner's equity from their personal assets. Or they may use partnership assets to settle with the deceased partner's estate. In both instances, the entries to record the withdrawal of the partner are similar to those presented earlier.
To facilitate payment from partnership assets, some partnerships obtain life insurance policies on each partner, with the partnership named as the beneficiary. The partnership then uses the proceeds from the insurance policy on the deceased partner to settle with the estate.