Accounting for Partnerships and Limited Liability Companies

1. 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. • Advantages • More financial resources than a proprietorship • Additional management skills • Disadvantages • Limited life • Unlimited liability • Co-ownership of partnership property • Mutual agency

7. 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.

8. 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.

9. 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

10. 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.

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

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

13. 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

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

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

16. 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.

17. 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.

18. 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

19. 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.

20. 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

21. 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

22. 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.

23. 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

24. 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

25. 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.

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 0 12-2 Dividing Income—Allowances Exceed Net Income Assume the same facts as before except that the net income is only $100,000.

33. 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

34. 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

35. 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

36. 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

37. 0 12-3 Objective 3 Describe and illustrate the accounting for partner admission and withdrawal.

38. 0 12-3 Admitting a Partner A person may be admitted to a partnership only with the consent of all the current partners by: 1. Purchasing an interest from one or more of the current partners. 2. Contributing assets to the partnership.

39. 0 12-3 Purchasing an Interest in a Partnership Partners Tom Andrews and Nathan Bell have capital balances of $50,000 each. On June 1, each sells one-fifth of his equity to Joe Canter for $10,000 in cash.

40. 0 12-3 The only entry required in the partnership accounts is as follows: June 1 Tom Andrews, Capital 10 000 00 Nathan Bell, Capital 10 000 00 Joe Canter, Capital 20 000 00 40

41. 0 12-3 The effect of the transaction on the partnership accounts is presented in the following diagram: Partnership Accounts Andrew, Capital 50,000 10,000 Carter, Capital 20,000 Bell, Capital 10,000 50,000 41

42. 0 12-3 LLC Alternative June 1 Tom Andrew, Member Equity 10 000 00 Nathan Bell, Member Equity 10 000 00 Joe Canter, Member Equity 20 000 00 42

43. 0 12-3 Contributing Assets to a Partnership Partners Donald Lewis and Gerald Morton have capital balances of $35,000 and $25,000, respectively. On June 1, Sharon Nelson joins the partnership by permission and makes an investment of $20,000 cash.

44. 0 12-3 The entry to record this transaction is as follows: June 1 Cash 20 000 00 Sharon Nelson, Capital 20 000 00 44

45. Lewis, Capital 35,000 20,000 Morton, Capital 20,000 25,000 0 12-3 The effect of the transaction on the partnership accounts is presented in the following diagram: Partnership Accounts Net Assets 60,000 Nelson, Capital 45

46. 0 12-3 LLC Alternative June 1 Cash 20 000 00 Sharon Nelson, Member Equity 20 000 00 46

47. 0 12-3 Revaluation of Assets If the asset accounts do not reflect approximate current market values when a new partner is admitted, the accounts should be adjusted (increased or decreased) before the new partner is admitted.

48. 0 12-3 Partners Donald Lewis and Gerald Morton have capital balances of $35,000 and $25,000, respectively. The balance in Merchandise Inventory is $14,000 and the current replacement value is $17,000. The partners share net income equally.

49. 0 12-3 The revaluation is recorded as follows: June 1 Merchandise Inventory 3 000 00 Donald Lewis, Capital 1 500 00 Gerald Morton, Capital 1 500 00 Because the LLC alternative follows a pattern of replacing “Capital” with “Member Equity,” the LLC entry will not be shown again. 49

50. Example Exercise 12-3 0 12-3 Blake Nelson invested $45,000 in the Lawrence & Kerry partnership for ownership equity of $45,000. Prior to the investment land was revalued to a market value of $260,000 from a book value of $200,000. Lynne Lawrence and Tim Kerry share net income in a 1:2 ratio. • Provide the journal entry for the revaluation of land. • Provide the journal entry to admit Nelson. 50