ACT3121 INTERMEDIATE FINANCIAL ACCOUNTING I (WEEK 2)

1. ACT3121 INTERMEDIATE FINANCIAL ACCOUNTING I (WEEK 2) SEMESTER TWO 2005/06 GROUP 5 (BBA) PN ASNA ATQA ABDULLAH ROOM A208, DIRECT LINE 89467636 asnaatqa@econ.upm.edu.my

2. Change in Partnership Structure • Limited life of partnership • Change in partnership structure leads to dissolution of partnership in law. • Events that may change partnership structure are: • Admission of new partner • Retirement/Death of existing partner • Change in profit/loss sharing ratio

3. Change in Partnership Structure • Dissolution here means that the old partnership is legally terminated and a new partnership comes into existence. • This process does not necessarily affect the partnership business operation. • There are basically two types of admission and retirement: (1) Purchase/sale of an interest directly from/to existing partner (2) Contribute/withdrawal of assets to/from partnership • We will concentrate only on method two

4. Change in Partnership Structure • 3 things to be considered when change in structure happens: (1) Value of net tangible assets in old PS that is transferred to new PS  'REVALUATION' step (2) Value of intangible assets (i.e. goodwill) that may exist in old PS.  'GOODWILL' step (3) Other adjustments on EQUITY (injection/withdrawal of capital, errors and mistakes in P&L)  ‘EQUITY ADJUSTMENTS’ step

5. Change in Partnership Structure (1) Revaluation • 2 factors underlying revaluation of assets in partnership: • normal valuation is based on historical cost less depreciation which is based on estimates; • transfer from old partnership to a new partnership requires 'selling/purchase price' that reflects the partners' equitable share of net assets (including intangible assets like goodwill).

6. Change in Partnership Structure Revaluation step (i) - Pro-forma journal entries • Asset value goes up/Liability goes down Dt. Individual Asset/Liability Ct. Revaluation Account [To record value of asset goes up & liability goes down] • Asset value goes down/Liability goes up Dt. Revaluation account Ct. Individual Asset/Liability [To record value of asset goes down & liability goes up]

7. Change in Partnership Structure Revaluation step (ii) - Pro-forma journal entries • Net increase/decrease in revaluation account is closed to capital account (for both fixed and flexible capital method) • Net increase Dt. Revaluation Ct. Capital, partner(s) [Net increase from revaluation is distributed to partners according to old profit/loss sharing ratio] • Net decrease Dt. Capital, partner(s) Ct. Revaluation [Net decrease from revaluation is distributed to partners according to old profit/loss sharing ratio] *Note that profit/loss sharing ratio applies both to revenue and capital profit/loss.

8. Change in Partnership Structure (2) Goodwill • Definition = ability to earn profits in the future • = difference between value of business as a whole& the sum of values of identifiable net assets [i.e. total assets less total liabilities] • How goodwill arise? • Through purchase of business • Generated internally

9. Change in Partnership Structure (2) Goodwill (continued) • Calculation; many (e.g. average annual profits, average revenue, super profits, etc.) • Views on recording goodwill in accounts: • record purchase goodwill only • record both types of goodwill (purchased & internally generated) • not to record any goodwill • For partnership, we simply have 2 policies; record goodwill and not to record goodwill

10. Change in Partnership Structure Goodwill step (i) OR (ii)- Pro-forma journal entries • Goodwill is valued and distributed among partners in capital account (for both fixed and flexible capital method) Goodwill step (i) - Policy: record goodwill in accounts Dt. Goodwill Ct. Capital, partner(s) [Recognition of goodwill as an asset and distributed among old partners using old profit/loss sharing ratio]

11. Change in Partnership Structure Goodwill step (i) OR (ii)- Pro-forma journal entries Goodwill step (ii) - Policy: not to record goodwill in accounts Dt. Goodwill Ct. Capital, partner(s) [Recognition of goodwill as an asset and distributed among old partners using old profit/loss sharing ratio] & Dt. Capital, partner(s) Ct. Goodwill [Goodwill account is closed and charged to partners using new profit/loss sharing ratio]

12. Change in Partnership Structure (3) Equity adjustments step Admission of new partner • Injection of capital by new partner Dt. Cash (or other assets) Ct. Capital, new partner [New capital is contributed by new partner and credited to his/her capital account (for both equity method)]

13. Change in Partnership Structure (3) Equity adjustments step(continued) Retirement/ death of existing partner • Withdrawal of capital by retired/deceased partner • A partner may decide to use combination of following methods. Some advantages and disadvantages of each method. • 3 ways to withdraw capital (forcredit capital balance only) – (i), (ii) OR (iii) • If retired partners have debit capital balance – 2 situations

14. Change in Partnership Structure Retirement/ death of existing partner (credit) Equity adjustments steps (i), (ii) OR (iii) (i) Payment by cash/other assets at agreed value Dt. Capital, retired/deceased partner Ct. Cash (or other assets) [Capital balance is withdrawn by retired/deceased partner and debited to his/her capital account (for both equity method)]

15. Change in Partnership Structure Retirement/ death of existing partner (credit) Equity adjustments steps (i), (ii) OR (iii) (ii) Capital balance is converted to a liability (loan) that carries interest on loan. Dt. Capital, retired/deceased partner Ct. Liability (loan) [Capital balance is converted to a loan and debited to his/her capital account (for both equity method)]

16. Change in Partnership Structure Retirement/ death of existing partner (credit) Equity adjustments steps (i), (ii) OR (iii) (iii) Capital balance is converted to an annuity that pays fixed sum every regular interval up to infinity (for life) Dt. Capital, retired/deceased partner Ct. Annuity (liability) [Capital balance is converted to annuity and debited to his/her capital account (for both equity method)]

17. Change in Partnership Structure Retirement/ death of existing partner (debit) Equity adjustment - Situation 1 Injection of capital by retired/deceased partner (for solvent partners with debit capital balance) Dt. Cash/other assets Ct. Capital, retired/deceased partner(s) [Retired/deceased partner(s) has to bring in cash to settle his obligation to partnership business]

18. Change in Partnership Structure Retirement/ death of existing partner (debit) Equity adjustment - Situation 2 Settlement of obligation by retired/deceased partner (for insolvent partner* with debit capital balance) - Garner vs. Murray rule subject to partnership agreement • First step: The insolvent and retired/deceased partner’s debit balance is absorbed by the other solvent partners using last capital balance ratio (GM rule) Dt. Capital, solvent partner(s) Ct. Capital, retired/deceased partner(s) [Solvent partners have to share the burden of the insolvent partner’s debt using last capital balance ratio] *Note that if any ONE partner is declared bankrupt, the partnership is automatically dissolved

19. Change in Partnership Structure Retirement/ death of existing partner (debit) Equity adjustment - Situation 2 • Second step: The solvent partners’ credit capital balance will be automatically deducted by the above absorption. If the solvent partners have debit capital balance, they have to bring in cash or other assets to settle his obligation to partnership business. Dt. Cash/other assets Ct. Capital, solvent partner(s) [Solvent partner(s) with debit capital balance has to bring in cash to settle his obligation to partnership business]

20. Change in Partnership Structure (3) Equity adjustments step (continued) Change in profit sharing ratio No equity adjustment is needed

21. Mistakes / Omissions of P&L items (i) Increase income/ Decrease expense (e.g. omission of dividend income) Dt. Cash/other assets/debtors Ct. Current, partner(s) – fixed capital method OR Ct. Capital, partner(s) – flexible capital method [Net increase in income /decrease in expense is distributed to partners according to old profit/loss sharing ratio]

22. Mistakes / Omissions of P&L items (ii) Decrease income/ Increase expense (e.g. understatement of operating expense) Dt. Current, partner(s) – fixed capital method OR Dt. Capital, partner(s) – flexible capital method Ct. Cash/accrued liability/ OR Ct.*Current(fixed) /Capital(flexible), partner(s) [Net decrease in income / increase in expense is distributed to partners according to old profit/loss sharing ratio] *If partner(s) use his own asset to pay for business expense (P&L)

23. Mistakes / Omissions of P&L Appropriation items (i) Increase interest on drawings + Decrease interest on capital & salaries • Fixed capital method Dt. Current, effected partner(s) Ct. Current, all partner(s) [Increase/decrease of above is distributed to partners according to old profit/loss sharing ratio] • Flexible capital method Dt. Capital, effected partner(s) Ct. Capital, all partner(s) [Increase/decrease of above is distributed to partners according to old profit/loss sharing ratio]

24. Mistakes / Omissions of P&L Appropriation items (ii) Decrease interest on drawings + Increase interest on capital & salaries • Fixed capital method Dt. Current, all partner(s) Ct. Current, effected partner(s) [Increase/decrease of above is distributed to partners according to old profit/loss sharing ratio] • Flexible capital method Dt. Capital, all partner(s) Ct. Capital, effected partner(s) [Increase/decrease of above is distributed to partners according to old profit/loss sharing ratio]

25. EXERCISE WEEK 2 • Prepare your answers based on pro-forma journal entries discussed. • Please work in pairs. • Any pair of student may be required to present their answers on Thursday, 5 Jan 2006.

26. WEEK 3 PLAN • 10 Jan 2006 is a public holiday (Raya Haji) • 12 Jan 2006 – I have to attend a workshop on FRS • Our 3-hour replacement class ? • Suggested date & time: - 11 Jan 2006 (Wednesday), evening/night • Format of the slot: - 1 hour = test (part of the 10%) - 2 hours = lecture on introduction to company accounts