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Chapter 18

Chapter 18. Accounting for Partnerships. Partnership. Definition: An association of two or more persons who co-own a business for profit. Partnerships. Some partnerships have more than 1,000 partners, but most have fewer than 10 partners.

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Chapter 18

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  1. Chapter 18 Accounting for Partnerships

  2. Partnership • Definition: An association of two or more persons who co-own a business for profit. Chapter 18

  3. Partnerships • Some partnerships have more than 1,000 partners, but most have fewer than 10 partners. • Many partners operate in the area of personal services. They involve doctors, lawyers, accountants, and other professionals who provide personal services. Chapter 18

  4. Advantages of a Partnership • Easy to form. • Allows several people to combine their experience and talents. • Allows several people to combine their financial resources. • Usually has a better credit rating than individuals because of their combined resources. Chapter 18

  5. Disadvantages of a Partnership • Has unlimited liability. Each partner is individually responsible for the debts of the business. • Has mutual agency. Generally, each partner can enter into contracts that are binding on the business. Chapter 18

  6. Disadvantages of a Partnership • Has a limited life. A partnership is dissolved when any member dies or decides to leave the firm or when a new member is admitted to the firm. • Has a division of authority. Decisions must be reached by mutual agreement among the partners. Chapter 18

  7. Articles of Partnership • A partnership can be formed without a written agreement, but it is wise for the partners to sign a written, legally enforceable contract. • This contract is called the articles of partnership or the partnership agreement. Chapter 18

  8. Articles of Partnership • Contains many points. Among the most important are: • Method of dividing net income and net losses • Amount that each partner can withdraw • Responsibility and authority of each partner • Amount of time each partner will contribute • Amount of assets each partner will contribute Chapter 18

  9. Accounting for a Partnership • Most accounting procedures for a partnership are the same as those for a sole proprietorship. • However, there are differences in the way owner’s equity is handled. • Example: • A separate capital account must be used for each partner. Chapter 18

  10. Recording the Beginning Investment • When a partnership is formed, the partners may invest only cash or a combination of cash and other assets. • Other assets include: merchandise inventory, trucks, automobiles, equipment. • When physical assets such as merchandise inventory and trucks are invested, these assets should be appraised and should be recorded at their current market value. Chapter 18

  11. Recording the Beginning Investment • The following journal entries were recorded on January 2, 20X1, when Ann Myers and David Chu formed a partnership. Chapter 18

  12. Recording the Beginning Investment • 20X1 • Jan. 2 Cash 50,000 • Ann Myers, Capital 50,000 • Investment in firm. • 2 Cash 6,000 • Merchandise Inventory 30,000 • Delivery Van 10,000 • Store Equipment 4,000 • David Chu, Capital 50,000 • Investment in firm. Chapter 18

  13. Recording Withdrawals • A separate drawing account must be kept for each partner. • Any withdrawal of cash or other assets by a partner is debited to that partner’s drawing account. Chapter 18

  14. Recording Withdrawals • 20X1 • Jan. 31 Ann Myers, Drawing 2,000 • David Chu, Drawing 2,000 • Cash 4,000 • Withdrew cash for • personal use. Chapter 18

  15. Division of Net Income or Net Loss • Partners can agree on any method of dividing net income or net loss they wish. • The method chosen should be specified in the articles of partnership. • If no method is stated in the articles of partnership, the law presumes an equal division. • The share of net income or net loss assigned to each partner is known as the partner’s distributive share. Chapter 18

  16. Methods of Dividing Net Income or Net Loss • Based on: • a fractional share to each partner • ratio of the partners’ capital investments • salary allowances to the partners • interest allowances to the partners • combination of salary and interest allowances to the partners Chapter 18

  17. Division of Net IncomeFractional Share • Suppose John Diaz and Paul McKay use a profit-sharing ratio of 3 to 2. • This ratio can be expressed in the following fractional shares: 3/5 for Diaz and 2/5 for McKay. • The denominator 5 in the fractions is found by adding 3 and 2, the partners’ shares. Chapter 18

  18. Division of Net IncomeFractional Share • In 20X1, the firm earned a net income of $60,000. • Share to Diaz: 3/5 of $60,000 = $36,000 • Share to McKay: 2/5 of $60,000 = 24,000 • Total $60,000 Chapter 18

  19. Division of Net IncomeRatio of Partners’ Investments • Ellen Reed invested $50,000 in a partnership, and Kim Hall invested $25,000. • Reed’s investment is 2/3 of the total capital of $75,000. Hall’s investment is 1/3 of the total capital. • Reed and Hall use this investment ratio of 2 to 1 as their profit-sharing ratio. Chapter 18

  20. Division of Net IncomeRatio of Partners’ Investments • In 20X1, the firm earned a net income of $45,000. • Share to Reed: 2/3 of $45,000 = $30,000 • Share to Hall: 1/3 of $45,000 = 15,000 • Total $45,000 Chapter 18

  21. Division of Net IncomeSalary Allowances • Marie Costa and Dan Evans are partners. Costa spends more time working at the firm than Evans, but each invested the same amount of capital. Chapter 18

  22. Division of Net IncomeSalary Allowances To recognize the unequal labor but equal investment, the partners use the following profit-sharing arrangement. • A salary allowance of $2,500 per month to Costa. • A salary allowance of $2,000 per month to Evans. • Remaining net income to be divided equally. Chapter 18

  23. Division of Net IncomeSalary Allowances • Suppose the partnership of Costa and Evans earns a net income of $80,000 in 20X1. This amount is divided as follows. • Salary allowance to Costa: $2,500  12 = $30,000 • Salary allowance to Evans: $2,000  12 = 24,000 • Total $54,000 Chapter 18

  24. Division of Net IncomeSalary Allowances • Net income $80,000 • Less: Total salary allowances 54,000 • Remaining net income $26,000 • Share of remaining net income to each partner • $26,000  2 = $13,000 Chapter 18

  25. Division of Net IncomeSalary Allowances • Distribution of Net Income for 20X1 • Costa Evans Total • Salary allowances $30,000 $24,000 $54,000 • Remaining net income 13,000 13,000 26,000 • Totals $43,000 $37,000 $80,000 Chapter 18

  26. Division of Net IncomeInterest Allowances • Joy Wilson and Terry O’Neal form a partnership. Wilson has a great deal of business experience but only $20,000 to invest. O’Neal has little experience but $80,000 to invest. Chapter 18

  27. Division of Net IncomeInterest Allowances • Wilson and O’Neal agree to the following profit-sharing arrangement. • An interest allowance of 10% to each partner. • The remaining net income to be divided equally. Chapter 18

  28. Division of Net IncomeInterest Allowances • In 20X1, Wilson and O’Neal had a net income of $78,000. • Interest allowance to Wilson: $20,000  .10 = $ 2,000 • Interest allowance to O’Neal: $80,000  .10 = 8,000 • Total $10,000 Chapter 18

  29. Division of Net IncomeInterest Allowances • Net income $78,000 • Less: Interest allowances 10,000 • Remaining net income $68,000 • Share of remaining net income to each partner • $68,000  2 = $34,000 Chapter 18

  30. Division of Net IncomeSalary Allowances • Distribution of Net Income for 20X1 • Wilson O’Neal Total • Interest allowances $ 2,000 $ 8,000 $10,000 • Remaining net income 34,000 34,000 68,000 • Totals $36,000 $42,000 $78,000 Chapter 18

  31. Division of Net IncomeSalary and Interest Allowances • Suppose Joy Wilson and Terry O’Neal agree to the following combination of salary and interest allowances. • Salary allowance to Wilson: $30,000 per year • Salary allowance to O’Neal: $26,000 per year • Interest allowances: 12% to each partner. • Remaining net income to be divided equally. Chapter 18

  32. Division of Net IncomeSalary and Interest Allowances • In 20X1, there was a net income of $78,000. • Salary allowance to Wilson = $30,000 • Salary allowance to O’Neal = 26,000 • Total $56,000 • Interest allowance to Wilson: $20,000  .12 = $ 2,400 • Interest allowance to O’Neal: $80,000  .12 = 9,600 • Total $12,000 Chapter 18

  33. Division of Net IncomeSalary and Interest Allowances • Net income $78,000 • Less: Salary allowances $56,000 • Interest allowances 12,000 68,000 • Remaining net income $10,000 • Share of remaining net income to each partner • $10,000  2 = $5,000 Chapter 18

  34. Division of Net IncomeSalary and Interest Allowances • Distribution of Net Income for 20X1 • Wilson O’Neal Total • Salary allowances $30,000 $26,000 $56,000 • Interest allowances 2,400 9,600 12,000 • Remaining net income 5,000 5,000 10,000 • Totals $37,400 $40,600 $78,000 Chapter 18

  35. Closing Entries for a Partnership • Step 1. Close the balance of each revenue to Income Summary. • Step 2. Close the balance of each cost and expense account to Income Summary. Chapter 18

  36. Closing Entries for a Partnership • Step 3. Close the balance of Income Summary (the net income or net loss for the period) to the partners’ capital accounts. • Step 4. Close the balances of the partners’ drawing accounts to their capital accounts. Chapter 18

  37. Closing Entries for a Partnership • In 20X1, the partnership of Ann Myers and David Chu had a net income of $82,000, which they divided equally. • The closing entries for the firm’s Income Summary account and drawing accounts are as follows. Chapter 18

  38. Closing Entries for a Partnership • 20X1 • Dec. 31 Income Summary 82,000 • Ann Myers, Capital 41,000 • David Chu, Capital 41,000 • 31 Ann Myers, Capital 35,000 • David Chu, Capital 37,000 • Ann Myers, Drawing 35,000 • David Chu, Drawing 37,000 Chapter 18

  39. Lakeville Computer SuppliesStatement of Owner’s EquityFor Year Ended December 31, 20X1 • A. Myers D. Chu Total • Capital, Jan. 2, 20X1 $50,000 $50,000 $100,000 • Net income for the year 41,000 41,000 82,000 • Totals $91,000 $91,000 $182,000 • Less: Withdrawals 35,000 37,000 72,000 • Capital, Dec. 31, 20X1 $56,000 $54,000 $110,000 Chapter 18

  40. Lakeville Computer SuppliesBalance SheetDecember 31, 20X1 • Owner’s Equity • Ann Myers, capital $56,000 • David Chu, capital 54,000 • Total owner’s equity $110,000 Chapter 18

  41. Admission of a New Partner • There are two ways for a new partner to be admitted to an existing firm. • By investing cash or other assets, which increases the total assets and total owners’ equity of the firm. • OR • By purchasing all or part of an existing partner’s interest, meaning the total assets and total owners’ equity of the firm do not change. Chapter 18

  42. Admission of a New Partner Investing assets equal to equity received • On January 2, 20X3, Ann Myers and David Chu needed more capital to expand operations. • They decided to admit a new partner, Scott Allen, who agreed to invest $60,000. • This amount is equal to the balance of each existing partner’s capital account on January 2, 20X3. Chapter 18

  43. Admission of a New Partner Investing assets equal to equity received • 20X3 • Jan. 2 Cash 60,000 • Scott Allen, Capital 60,000 • Admitted a new partner • to the firm. Chapter 18

  44. Recognizing Goodwill • Sometimes the existing partners give the new partner an interest that is greater than the assets invested. • Suppose that Scott Allen invests $50,000, but Myers and Chu credit him with capital of $60,000. • The difference of $10,000 is debited to an intangible asset account called Goodwill. Chapter 18

  45. Recognizing Goodwill • 20X3 • Jan. 2 Cash 50,000 • Goodwill 10,000 • Scott Allen, Capital 60,000 • Admitted a new partner • with goodwill to the firm. Chapter 18

  46. Granting a Bonus to a New Partner • Another way to credit a new partner with more capital than he or she invests is to grant a bonus. • The capital accounts of the existing partners are reduced by the amount of the bonus according to their profit-sharing ratio. Chapter 18

  47. Granting a Bonus to a New Partner • 20X3 • Jan. 2 Cash 50,000 • Ann Myers, Capital 5,000 • David Chu, Capital 5,000 • Scott Allen, Capital 60,000 • Admitted a new partner • with a bonus. Chapter 18

  48. Granting a Bonus to Existing Partners • Sometimes a new partner is anxious to join a successful firm and will pay a bonus to the existing partners. • Suppose Scott Allen is willing to pay $70,000 to Myers and Chu and receive credit for capital of $60,000. • The $10,000 difference is a bonus shared equally by Myers and Chu. Chapter 18

  49. Granting a Bonus to Existing Partners • 20X3 • Jan. 2 Cash 70,000 • Scott Allen, Capital 60,000 • Ann Myers, Capital 5,000 • David Chu, Capital 5,000 • Admitted a new partner • with a bonus to the • existing partners. Chapter 18

  50. Admission of a New Partner by the Purchase of Interest • A new partner may buy all or part of the interest of an existing partner. • Suppose Scott Allen pays $70,000 to David Chu for Chu’s $60,000 interest in the firm of Myers and Chu. • There is no increase in the assets of the firm, merely a transfer of capital. Chapter 18

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