Partnerships

2. Partnerships • This chapter focuses on the formation and operation of partnerships, including accounting for the addition of new partners and the retirement of a present partner. • Chapter 16 presents the accounting for termination and liquidation of partnerships.

3. Partnerships • The number of partnerships in the United States has been estimated to be between 1.5 and 2.0 million, second only to sole proprietorships, which number in excess of 15 million businesses. • In contrast, there are about 1 million corporations in the United States.

4. Partnerships • Partnerships are a popular form of business because they are easy to form and because they allow several individuals to combine their talents and skills in a particular business venture.

5. Partnerships • In addition, partnerships provide a means of obtaining more equity capital than a single individual can obtain and allow the sharing of risks for rapidly growing businesses.

6. Partnerships • Accounting for partnerships requires recognition of several important factors. • First, from an accounting viewpoint, the partnership is a separate business entity. • The Internal Revenue Code, however, views the partnership form as a conduit only, not separable from the business interests of the individual partners.

7. Partnerships • Second, although many partnerships account for their operations using accrual accounting, some partnerships use the cash basis or modified cash basis of accounting. • These alternatives are allowed because the partnership records are maintained for the partners and must reflect their information needs.

8. Partnerships • The partnership’s financial statements are usually prepared only for the partners, but occasionally for the partnership’s creditors. • Unlike publicly traded corporations, most partnerships are not required to have annual audits of their financial statements.

9. Partnerships • Although many partnerships adhere to generally accepted accounting principles (GAAP), deviations from GAAP are found in practice. • The specific needs of the partners should be the primary criteria for determining the accounting policies to be used for a specific partnership.

10. Definition of a Partnership • Section 202 of the UPA 1997 states that, “...the association of two or more persons to carry on as co-owners of a business for profit forms a partnership...”. This encompasses three distinct factors: • 1. Association of two or more persons. • 2. To carry on as co-owners. • 3. Business for profit.

11. Formation of a Partnership • The agreement to form a partnership may be as informal as a handshake or as formal as a many paged partnership agreement . • Each partner must agree to the formation agreement, and partners are strongly advised to have a formal written agreement in order to avoid potential problems that may arise during the operation of the business.

12. Partnership Formation • At the formation of a partnership, it is necessary to assign a proper value to the non-cash assets and liabilities contributed by partners. • An item contributed by a partner becomes partnership property.

13. Partnership Formation • The partnership must clearly distinguish between capital contributions and loans made to the partnership by individual partners.

14. Partnership Formation • Loan arrangements should be evidenced by promissory notes or other legal documents necessary to show that a loan arrangement exists between the partnership and an individual partner.

15. Partnership Formation • The contributed assets should be valued at their fair values, which may require appraisals or other valuation techniques. • Liabilities assumed by the partnership should be valued at the present value of the remaining cash flows.

16. Partnership Formation • The individual partners must agree to the percentage of equity that each will have in the net assets of the partnership. • Generally, the capital balance is determined by the proportionate share of each partner’s capital contribution.

17. Partnership Formation • For example, if A contributes 70 percent of the net assets in a partnership with B, then A will have a 70 percent capital share and B will have a 30 percent capital share.

18. Partnership Formation • In recognition of intangible factors, such as a partner’s special expertise or necessary business connections, however, partners may agree to any proportional division of capital. • Therefore, before recording the initial capital contribution, all partners must agree on the valuation of the net assets and on each partner’s capital share.

19. Other Major Characteristics of Partnerships • After a state adopts the provisions of the UPA 1997, all partnerships formed in that state are regulated by the act. Partnerships that do not have a formal partnership agreement are also regulated by the UPA act of 1997.

20. Limited Partnerships • Many persons view the possibility of personal liability for a partnership’s obligations as a major disadvantage of the general partnership form of business. • For this reason, sometimes people become limited partners in one of the several limited partnership forms listed on the next slide:

21. Limited Partnerships • Limited Partnership (LP): In a LP, there is at least one general partner and one or more limited partners. • Limited Liability Partnerships (LLP): A LLP is one which each partner has some degree of liability shield • Limited Liability Limited Partnership (LLLP): In most states, a limited partnership may elect to become a limited liability limited partnership.

22. Key Observations • Note that the partnership is an accounting entity separate from each of the partners and that the assets and liabilities are recorded at their market values at the time of contribution. • No accumulated depreciation is carried forward from the sole proprietorship to the partnership. • All liabilities are recognized and recorded.

23. Key Observations • The key point is that the partners may allocate the capital contributions in any manner they desire. • The accountant must be sure that all partners agree to the allocation and must then record it accordingly.

24. Partner’s Accounts • The partnership may maintain several accounts for each partner in its accounting records. • These partner’s accounts are as follows: • Capital Accounts. • Drawing Accounts. • Loan Accounts.

25. Capital Accounts • The initial investment of a partner, any subsequent capital contributions, profit or loss distributions, and any withdrawals of capital by the partner are ultimately recorded in the partner’s capital account. • The balance in the capital account represents the partner’s share of the net assets of the partnership.

26. Capital Accounts • Each partner has one capital account, which usually has a credit balance. • On occasion, a partner’s capital account may have a debit balance, called a deficiency or sometimes termed a deficit, which occurs because the partner’s share of losses and withdrawals exceeds his or her capital contribution and share of profits.

27. Capital Accounts • A deficiency is usually eliminated by additional capital contributions.

28. Drawing Accounts • Partners generally make withdrawals of assets from the partnership during the year in anticipation of profits.

29. Drawing Accounts • A separate drawing account often is used to record the periodic withdrawals and is then closed to the partner’s capital account at the end of the period. For example: Blue, Drawing $$$ Cash $$$

30. Drawing Accounts • Noncash drawings should be valued at their fair market values (FMV)—not book value (BV)—at the date of the withdrawal. For example: Blue, Drawing FMV Auto BV Gain Difference* *That is, FMV less BV

31. Drawing Accounts • A few partnerships make an exception to the rule of market value for withdrawals of inventory by the partners. • They record withdrawal of inventory at cost, thereby not recording a gain or loss on these drawings.

32. Loan Accounts • The partnership may look to its present partners for additional financing. • Any loans between a partner and the partnership should always be accompanied by proper loan documentation such as promissory note. • A loan from a partner is shown as a payable on the partnership’s books, the same as any other loan.

33. Loan Accounts • Unless all partners agree otherwise, the partnership is obligated to pay interest on the loan to the individual partner. • Note that interest is not required to be paid on capital investments unless the partnership agreement states that capital interest is to be paid.

34. Loan Accounts • Interest on loans is recorded as an operating expense by the partnership. • Alternatively, the partnership may lend money to a partner, in which case it records a loan receivable from the partner.

35. Loan Accounts • Again, unless it is otherwise agreed by all partners, these loans should bear interest and the interest income is recognized on the partnership’s income statement.

36. Loan Accounts • A loan to/from a partner is a related-party transaction for which separate footnote disclosure is required, and it must be reported as a separate balance sheet item, not included with other liabilities.

37. Allocating Profit or Loss • Profit or loss is allocated to the partners at the end of each period in accordance with the partnership agreement. • If no partnership agreement exists, section 401 of the UPA 1997 declares that profits and losses are to be shared equally by all partners.

38. Allocating Profit or Loss • A wide range of profit distribution plans is found in the business world. • Some partnerships have straightforward distribution plans, while others have extremely complex ones.

39. Allocating Profit or Loss • It is the accountant’s responsibility to distribute the profit or loss according to the partnership agreement regardless of how simple or complex that agreement is.

40. Allocating Profit or Loss • Profit distributions are similar to dividends for a corporation: these distributions are not included in the partnership’s income statement, regardless of how profit is distributed. • Stated otherwise, profit distributions are recorded directly into the partner’s capital accounts, not as expense items.

41. Allocating Profit or Loss • Most partnerships use one or more of the following distribution methods: • Preselected ratio. • Interest on capital balances. • Salaries to partners. • Bonuses to partners.

42. Preselected Ratio • Preselected ratios are usually the result of negotiations between the partners. • Some partnerships have different ratios if the firm suffers a loss versus earns a profit.

43. Preselected Ratio • Ratios for profit distributions may be based on the percentage of total partnership capital, time and effort invested in the partnership, or a variety of other factors.

44. Interest on Capital Balances • Distributing partnership income based on interest on capital balances recognizes the contribution of the partners’ capital investments to the profit-generating capacity of the partnership. • This interest on capital is not an expense of the partnership; it is a distribution of profits.

45. Salaries to Partners • Section 401 of the UPA 1997 states that a partner is not entitled to compensation for services performed for the partnership except for reasonable compensation for services in winding up the business of the partnership.

46. Salaries to Partners • If one or more of the partners’ services are important to the partnership, the profit distribution agreement may provide for salaries or bonuses. • Again, these salaries paid to partners are a form of profit distribution and are not an expense of the partnership.

47. Bonuses to Partners • Occasionally, the distribution process may depend on the size of the profit or may differ if the partnership has a loss for the period. • For example, salaries to partners might be paid only if revenue exceeds expenses by a certain amount.

48. Bonuses to Partners • The accountant must carefully read the partnership agreement to determine the precise profit distribution plan for the specific circumstances at the time.

49. Allocating Profit or Loss • The profit or loss distribution is recorded with a closing entry at the end of each period. • The revenue and expenses are closed into an income summary account or directly into the partners’ capital accounts.

50. Allocating Profit or Loss • In addition, the drawing accounts are closed to the capital accounts at the end of the period. • An example is provided on the next two slides.