Accounting for Partnerships and Limited Liability Companies

1. 0 12 Accounting for Partnerships and Limited Liability Companies

2. 0 After studying this chapter, you should be able to: Describe the basic characteristics of proprietorships, partnerships, and limited liability companies. Describe and illustrate the accounting for forming a partnership and for dividing the net income and net loss of a partnership.

3. 0 After studying this chapter, you should be able to: Describe and illustrate the accounting for partner admission and withdrawal. Describe and illustrate the accounting for liquidating a partnership. Prepare the statement of partnership equity.

4. 0 12-1 Objective 1 Describe the basic characteristics of proprietorships, partnerships, and limited liability companies.

5. 0 12-1 Proprietorship A proprietorship is a business enterprise owned by a single individual. • Advantages • Simple to form • Ability to be one’s own boss • Disadvantages • Difficulty in raising large amounts of capital • Unlimited liability

6. 0 12-1 Partnership A partnershipis an association of two or more individuals who own and manage a business for profit.

7. Characteristics of Partnerships Voluntary Association Limited Life Partnership Agreement Taxation Mutual Agency Unlimited Liability

8. 0 12-1 Partnership A partnershipis an association of two or more individuals who own and manage a business for profit. • Advantages • More financial resources than a proprietorship • Additional management skills • Disadvantages • Limited life • Unlimited liability • Co-ownership of partnership property • Mutual agency

9. 0 12-1 Partnership • An important right of partners is to participate inthe income of the partnership. • A partnership, like a proprietorship, is a nontaxable entity. • A partnership is created by a contract, known as the partnership agreement or articles of partnership.

10. 0 12-1 Limited Partnership A variant of the regular partnership is a limited partnership. This form of partnership allows partners who are not involved in the operations of the partnership to retain limited liability.

11. 0 12-1 Limited Liability Companies • Combines the advantages of the corporate and partnership forms. • LLCs must file “articles of organization” with state governmental authorities. • Owners are termed “members” rather than “partners.” • Members must create an operating agreement. (Continued) 9

12. 0 12-1 Limited Liability Companies • An LLC may elect to be treated as a partnership for tax purposes. • Most operating agreements specify continuity of life for the LLC, even when a member withdraws. • Members may elect operating the LLC as a “member-managed” entity. • An LLC provides limited liability for the members.

13. Limited Partnerships Limited Liability Partnerships Limited Liability Corporations • General partners assume management duties and unlimited liability for partnership debts. • Limited partners have no personal liability beyond invested amounts. • Protects innocent partners from malpractice or negligence claims. • Most states hold all partners personally liable for partnership debts. • Owners have same limited liability feature as owners of a corporation. • A limited liability corporation typically has a limited life. Organizations with Partnership Characteristics

14. Choosing a Business Form Many factors should be considered when choosing the proper business form.

15. 0 12-1 Characteristics of Proprietorships, Partnerships, and Limited Liability companies 2 Ease of Formation Proprietorship Simple Partnership Moderate LLC Moderate 11

16. 0 12-1 Characteristics of Proprietorships, Partnerships, and Limited Liability companies 2 Legal Liability Proprietorship No limitation Partnership No limitation LLC Limited liability 12

17. 0 12-1 Characteristics of Proprietorships, Partnerships, and Limited Liability companies 2 Taxation Proprietorship Nontaxable* Partnership Nontaxable* LLC Nontaxable** *Pass-through entity **Pass-through entity by election 13

18. 0 12-1 Characteristics of Proprietorships, Partnerships, and Limited Liability companies 2 Limitation on Life of Entity Proprietorship Yes Partnership Yes LLC No 14

19. 0 12-1 Characteristics of Proprietorships, Partnerships, and Limited Liability companies 2 Access to Capital Proprietorship Limited Partnership Limited LLC Average 15

20. 0 12-2 Objective 2 Describe and illustrate the accounting for forming a partnership and for dividing the net income and net loss of a partnership.

21. Organizing a Partnership Partners can invest both assets and liabilities in the partnership. Assets and liabilities are recorded at an agreed-upon value, normally fair market value. Contributions increase the partner’s capital account. Withdrawals decrease the partner’s capital account.

22. 0 12-2 Forming a Partnership Joseph Stevens and Earl Foster agree to combine their hardware businesses in a partnership. Each is to contribute certain amounts of cash and other assets. They also agree that the partnership is to assume the liabilities of the separate businesses.

23. 0 12-2 Stevens’ Transfer of Assets, Liability, and Equity Apr. 1 Cash 7 200 00 Accounts Receivable 16 300 00 Merchandise Inventory 28 700 00 Store Equipment 5 400 00 Office Equipment 1 500 00 Allowance for Doubtful Accounts 1 500 00 Accounts Payable 2 600 00 Joseph Stevens, Capital 55 000 00 18

24. 0 12-2 A similar entry would record the assets contributed and the liabilities transferred by Foster. In each entry, the noncash assets are recorded at values agreed upon by the partners. These values normally represent current market values.

25. Example Exercise 12-1 0 12-2 Reese Howell contributed equipment, inventory, and $34,000 cash to a partnership. The equipment had a book value of $23,000 and market value of $29,000. The inventory had a book value of $60,000, but only had a market value of $15,000, due to obsolescence. The partnership also assumed a $12,000 note payable owed by Howell that was used originally to purchase the equipment. Provide the journal entry for Howell’s contribution to the partnership. 20

26. Follow My Example 12-1 0 12-2 Cash 34,000 Inventory 15,000 Equipment 29,000 Notes Payable 12,000 Reese Howell, Capital 66,000 For Practice: PE 12-1A, PE 12-1B 21

27. In the absence of an agreement, the Uniform Partnership Act says that the income or loss is shared equally by the partners.Three frequently used methods to divide income or loss are: A stated ratio The ratio of capital balances Salary and interest allowances and any remainder in a fixed ratio. Dividing Income or Loss Let’s look at each of these methods!

28. Allocation on Stated Ratios Greene and Redd agree to a three-fourths, one-fourth allocation of partnership income and loss, respectively. For 2008, net income is $60,000. Prepare the closing entry for Income Summary that will allocate the income to the partners based on their agreement.

29. Allocation on Stated Ratios Greene and Redd agree to a three-fourths, one-fourth allocation of partnership income and loss, respectively. For 2008, net income is $60,000. Greene: $60,000 (3/4) = $45,000 Redd: $60,000 (1/4) = $15,000

30. Allocation on Capital Balances Greene’s capital balance is $80,000 and Redd’s capital balance is $40,000. The partnership agreement calls for income or loss to be allocated based on the relative capital balances. Net income for 2008 is $60,000. Prepare the closing entry for Income Summary that will allocate the income to the partners based on their agreement.

31. Allocation on Capital Balances Greene’s capital balance is $80,000 and Redd’s capital balance is $40,000. The partnership agreement calls for income or loss to be allocated based on the relative capital balances. Net income for 2008 is $60,000. Greene: $60,000 ($80,000/$120,000) = $40,000 Redd: $60,000 ($40,000/$120,000) = $20,000

32. Greene and Redd’s partnership agreement contains the following information: Greene receives $15,000 and Redd receives $10,000 as annual salaries. Each partner is allowed an annual interest allowance of 5% on the beginning-of-year capital balance. Any remaining balance of income or loss is allocated equally. Net income for 2008 is $60,000. What amount of the net income will be allocated to each partner based on their agreement? Allocation on Services, Capital, and Stated Ratios

33. Allocation on Services, Capital, and Stated Ratios If the allowances exceed net income, the deficit would be allocated equally, just as the excess is in the example above.

34. 0 12-2 Dividing Income—Services of Partners The partnership agreement of Jennifer Stone and Crystal Mills provides for Stone to receive a monthly allowance of $5,000 ($60,000 annually) and Mills is to receive $4,000 a month ($48,000 annually). If there is any remaining net income, it is to be divided equally. The firm had a net income of $150,000 for the year.

35. Division of net income $81,000 $69,000 $150,000 0 12-2 Division of Net Income J. Stone C. Mills Total Annual salary allowance $60,000 $48,000 $108,000 Remaining income 21,000 21,000 42,000 to journal entry (Slide 24) 23

36. 0 12-2 The entry for dividing net income is as follows: Dec. 31 Income Summary 150 000 00 Jennifer Stone, Capital 81 000 00 Crystal Mills, Capital 69 000 00 24

37. 0 12-2 Dividing Income—Services of Partners and Investments The partnership agreement for Stone and Mills divides income as follows: • Monthly salary allowance of $5,000 for Stone and $4,000 for Mills. • Interest of 12% on each partner’s capital balance on January 1. • If there is any remaining net income, it is to be divided equally between the partners.

38. 0 12-2 Division of Net Income Net income of $150,000 is divided. J. Stone C. Mills Total Salary allowance $60,000 $48,000 $108,000 Interest allowance 19,200 14,400 33,600 26

39. 0 12-2 Division of Net Income Net income of $150,000 is divided. J. Stone C. Mills Total Salary allowance $60,000 $48,000 $108,000 Interest allowance 19,200 14,400 33,600 12% x Stone’s capital account balance on Jan. 1 of $160,000 27

40. 0 12-2 Division of Net Income Net income of $150,000 is divided. J. Stone C. Mills Total Salary allowance $60,000 $48,000 $108,000 Interest allowance 19,200 14,400 33,600 12% x Mills’ capital account balance on Jan. 1 of $120,000 28

41. J. Stone C. Mills Total Salary allowance $60,000 $48,000 $108,000 Interest allowance 19,200 14,400 33,600 Remaining income 4,200 4,200 8,400 Division of net income $83,400 $66,600 $150,000 0 12-2 Division of Net Income Net income of $150,000 is divided. 29

42. 0 12-2 The entry for dividing net income is as follows: Dec. 31 Income Summary 150 000 00 Jennifer Stone, Capital 83 400 00 Crystal Mills, Capital 66 600 00 30

43. Dec. 31 Income Summary 150 000 00 Jennifer Stone, Member Equity 83 400 00 Crystal Mills, Member Equity 66 600 00 Note the use of “Member Equity” instead of “Capital” for LLC. 0 12-2 LLC Alternative The entry for dividing net income is as follows: 31

44. 0 12-2 Dividing Income—Allowances Exceed Net Income Assume the same facts as before except that the net income is only $100,000.

45. 0 12-2 Division of Net Income Net income of $100,000 is divided. J. Stone C. Mills Total Salary allowance $60,000 $48,000 $108,000 Interest allowance 19,200 14,400 33,600 Total $79,200 $62,400 $141,600 This amount exceeds net income by $41,600. 33

46. Net income $58,400 $41,600 $100,000 0 12-2 Division of Net Income Net income of $100,000 is divided. J. Stone C. Mills Total Salary allowance $60,000 $48,000 $108,000 Interest allowance 19,200 14,400 33,600 Total $79,200 $62,400 $141,600 Deduct excess of allowance over income 20,800 20,800 <41,600> 34

47. Example Exercise 12-2 0 12-2 Steve Prince and Chelsy Bennick formed a partnership, dividing income as follows: • Annual salary allowance to Prince of $42,000. • Interest of 9% on each partner’s capital balance on January 1. • Any remaining net income divided equally. Prince and Bennick had $20,000 and $150,000 in their January 1 capital balances, respectively. Net income for the year was $240,000. How much net income should be distributed to Prince? 35

48. Follow My Example 12-2 Monthly salary $ 42,000 Interest (9% x $20,000) 1,800 Remaining income 91,350* Total distributed to Prince $135,150 *($240,000 – $42,000 – $1,800 – $13,500) x 50% 0 12-2 For Practice: PE 12-2A, PE 12-2B 36

49. 0 12-3 Objective 3 Describe and illustrate the accounting for partner admission and withdrawal.

50. When the makeup of the partnership changes, the partnership is dissolved. A new partnership may be immediately formed. New partner acquires partnership interest by: Purchasing it from the other partners, or Investing assets in the partnership. Admission of a Partner