14
Chapter 14: Partnerships - Formation and Operation
I. Defined:
A partnership is an association of two or more people or organizations formed to engage in some economic activity.
II. Advantages:
A. Partners’ abilities:
B. Ease of formation:
C. No partnership income taxes:
III. Disadvantages:
A. Unlimited legal liability:
B. Obtaining resources:
IV. Owner’s Investments:
Unlike corporation owners’ investments that are recorded in stockholders’ equity accounts, owners’ investments in partnerships are recorded in capital accounts.
Assume that Lowell and Nashua form a partnership to provide internet art services. Lowell is an internet expert and Nashua has a significant amount of cash available from his previous business experience. To start the partnership, Lowell invests $10,000 and Nashua invests $40,000. The effects of their investments could be as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Cash / 50,000
Lowell, Capital / 10,000
Nashua, Capital / 40,000
If the partners agreed to give equal credit to each partner, the effects would be as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Cash / 50,000
Lowell, Capital / 25,000
Nashua, Capital / 25,000
Partners may agree to treat each other in any way they desire, as long as the arrangement is legal.
If partners invest resources other than cash, such resources are usually recorded at their fair market value.
The accounting terminology for partnerships differs from that of corporations.
V. Withdrawals:
Partners receive assets from a partnership by withdrawing them.
Asset withdrawals by partners are recorded in partner withdrawal accounts.
If Lowell withdrew $500 and Nashua withdrew $400 from their partnership, the effects would be as follows.
Date / Accounts / Debits / CreditsLowell, Drawing / 500
Nashua, Drawing / 400
Cash / 900
Each partner’s drawing account is a contra owners’ equity account (similar to the dividends account in a corporation). At the end of each accounting period, each partner’s drawing account is closed to the partner’s capital account.
If Lowell’s drawing account were closed to his capital account, the effects would be as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Lowell, Capital / 500
Lowell, Drawing / 500
VI. Income Allocation: Similar to corporations, at the end of each accounting period, partnership revenues and expenses are closed to income summary. Unlike corporations, however, in which income summary is closed to , partnership income summary is closed . This process of income allocation depends upon
Assume that the partnership agreement of Lowell and Nashua specifies that (1) each partner is to receive interest of 1% per month on his capital balance at the beginning of the month, (2) Lowell is to receive a monthly salary of $6,000 and Nashua is to receive $4,000, and (3) any remaining income is to be split equally between the partners. Assume that on April 1, 2007, Lowell’s capital balance was $12,000 and Nashua’s was $45,000. Assume also that the partnership’s income for April was $18,000. Based on this data, the partnership’s income would be distributed as shown below.
Item / Lowell / Nashua / TotalsTotals
Item / Lowell / Nashua / Totals
Interest
$12,000 x .01 / $120 / $0 / $120
$45,000 x .01 / $0 / $450 / $450
Salary / $6,000 / $4,000 / $10,000
Remaining income: $18,000 - $10,570 / $3,715 / $3,715 / $7,430
Totals / $9,835 / $8,165 / $18,000
The above income allocation affects the partnership as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Income Summary / 18,000
Lowell, Capital / 9,835
Nashua, Capital / 8,165
Assume that instead of $18,000, the partnership’s income for April was $9,000. Based on this data, the partnership’s income would be distributed as shown below.
Item / Lowell / Nashua / TotalsInterest
$12,000 x .01 / $120 / $0 / $120
$45,000 x .01 / $0 / $450 / $450
Salary / $6,000 / $4,000 / $10,000
Totals
Item / Lowell / Nashua / Totals
Interest
$12,000 x .01 / $120 / $0 / $120
$45,000 x .01 / $0 / $450 / $450
Salary / $6,000 / $4,000 / $10,000
Remaining income: $9,000 - $10,570 / ($785) / ($785) / ($1,570)
Totals / $5,335 / $3,665 / $9,000
The above income allocation affects the partnership as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Income Summary / 9,000
Lowell, Capital / 5,335
Nashua, Capital / 3,665
Assume that instead of $18,000, the partnership’s income for April was a $1,000 loss. Based on this data, the partnership’s income would be distributed as shown below.
Item / Lowell / Nashua / TotalsInterest
$12,000 x .01 / $120 / $0 / $120
$45,000 x .01 / $0 / $450 / $450
Salary / $6,000 / $4,000 / $10,000
Totals
Item / Lowell / Nashua / Totals
Interest
$12,000 x .01 / $120 / $0 / $120
$45,000 x .01 / $0 / $450 / $450
Salary / $6,000 / $4,000 / $10,000
Remaining income: - $1,000 - $10,570 / ($5,785) / ($5,785) / ($11,570)
Totals / $335 / ($1,335) / ($1,000)
The above income allocation affects the partnership as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Nashua, Capital / 1,335
Income Summary / 1,000
Lowell, Capital / 335
VII. Dissolution: Technically, a partnership is dissolved whenever there is
a change in partners.
A. Admission of a new partner: A new partner can be admitted to a partnership in two ways:
(1) the purchase of an existing partner’s interest directly from the partner
(2) the investing of resources directly in the partnership
1. Purchase of existing partner’s interest: When a new partner purchases an interest in a partnership by buying it directly from a current partner,
the current partner’s capital interest is eliminated from the partnership’s accounting records and the new partner’s interest is recorded.
For example, assume that Nashua sells his $65,000 capital interest to Orono for $78,000. In this case, Nashua receives $78,000 cash and Orono receives a $65,000 capital interest in the partnership. This method is called the book value method and the effects on the partnership would be as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Nashua, Capital / 65,000
Orono, Capital / 65,000
2. New partner investing resources directly in the partnership: When a new partner purchases an interest in a partnership by making payment directly to the partnership, the new partner’s capital interest is recorded.
In its simplest terms, the new partner’s capital interest is recorded at that dollar amount equal to the new partner’s percentage interest in the partnership.
For example, assume that Orono pays $30,000 to the Lowell and Nashua partnership for a 15% interest in the firm. Assume that immediately prior to the admission of Orono, the partners’ capital interests were as follows.
Partner / Partner’s Capital / %Lowell / $35,000 / 35%
Nashua / $65,000 / 65%
Totals / $100,000 / 100%
Orono’s $30,000 payment increases the partnership’s net assets to $130,000.
Orono’s 15% capital interest would be $19,500 ($130,000 x .15).
Since Orono paid $30,000 for a $19,500 interest in the partnership, the $10,500 excess payment ($30,000 - $19,500) would be allocated to the other partners according to their income sharing percentages.
In this case, the capital balances of Lowell and Nashua would each increase by $5,250 ($10,500 / 2), since they share income equally.
The effects on the partnership would be as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Cash / 30,000
Lowell, Capital / 5,250
Nashua, Capital / 5,250
Orono, Capital / 19,500
After the admission of Orono, the partners’ capital interests would be as follows.
Partner / Partner’s Capital / %Lowell / $40,250 / 31%
Nashua / $70,250 / 54%
Orono / $19,500 / 15%
Totals / $130,000 / 100%
B. Withdrawal of a partner: When a partner withdraws from a partnership, the partnership is
dissolved according to the partnership agreement. If other partners remain in the partnership, a new partnership is formed.
Assume that Lowell decides to withdraw from the partnership. Immediately prior to his withdrawal, the partners’ capital interests were as follows.
Partner / Partner’s Capital / Income Sharing %Lowell / $60,000 / 40%
Nashua / $100,000 / 40%
Orono / $50,000 / 20%
Totals / $210,000 / 100%
If the partnership agreement requires an appraisal of the partnership’s value before a partner withdraws and such an appraisal indicates that the partnership’s value is $300,000, Lowell would receive
$96,000 when he withdraws. The $96,000 was calculated as follows.
Item / AmountItem / Amount
Lowell capital balance / $60,000
Lowell share of excess partnership value: ($300,000 - $210,000) x .40 / $36,000
Total / $96,000
Lowell’s withdrawal would affect the partnership as follows.
Date / Accounts / Debits / CreditsDate / Accounts / Debits / Credits
Lowell, Capital / 60,000
Nashua, Capital / 24,000
Orono, Capital / 12,000
Cash / 96,000