CHAPTER
12
Accounting for Partnerships
Principles of
Financial
Accounting
12e
Needles
Powers
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Concepts Underlying Partnerships
 A partnership, as defined by the Uniform
Partnership Act, is an association of two or more
persons to carry on as co-owners of a business for
profit.
– Partnerships are treated as separate entities, with their
own accounting records and financial statements.
– Legally, there is no economic separation between a
partnership and its owners.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Characteristics of Partnerships
(slide 1 of 3)
 Voluntary association—A partnership is a voluntary
association of individuals. Therefore, a partner is legally
responsible for his or her partners’ actions within the scope
of the business.
 Partnership agreement—Although not required, it is good
business practice to have a written partnership agreement
that clearly states:
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Name, location, and purpose of the business
Names of the partners and their respective duties
Investments of each partner
Method of distributing income and losses
Procedures for the admission and withdrawal of partners, the
withdrawal of assets, and the liquidation of the business
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Characteristics of Partnerships
(slide 2 of 3)
 Limited life—A partnership has a limited life. It may be
dissolved when:
– a new partner is admitted
– a partner withdraws, goes bankrupt, is incapacitated, retires, or
dies
– the terms of the partnership agreement are met, such as when the
project for which the partnership was formed is completed
 Mutual agency—Each partner is an agent of the
partnership within the scope of the business. Because of this
mutual agency, any partner can bind the partnership to a
business agreement as long as he or she acts within the
scope of the company’s normal operations.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Characteristics of Partnerships
(slide 3 of 3)
 Unlimited liability—Each partner has personal unlimited
liability for all the debts of the partnership. If the assets of
the business are not enough to pay all the debts of the
business, creditors can seek payment from the personal
assets of each partner.
 Co-ownership of partnership property—When individuals
invest property in a partnership, the property becomes an
asset of the partnership and is owned jointly by the
partners.
 Participation in partnership income—Each partner has the
right to share in the partnership’s income and the
responsibility to share in its losses.
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Advantages and Disadvantages of
Partnerships
 Advantages
– Can be easy to form,
change, and dissolve.
– Facilitates the pooling of
capital resources and
individual talents.
– Has no corporate tax
burden.
– Gives the partners a certain
amount of freedom and
flexibility.
 Disadvantages
– The life of a partnership is
limited.
– One partner can bind the
partnership to a contract.
– Partners have unlimited
personal liability.
– It is more difficult for a
partnership to raise capital
than it is for a corporation.
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Accounting for Partners’ Equity
 Accounting for a partnership is similar to
accounting for a sole proprietorship, but there are
differences.
– Owner’s equity in a partnership is called partners’
equity.
– It is necessary to divide the income and losses of the
company between the partners.
– It is necessary to maintain separate Capital and
Withdrawals accounts for each partner.
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Distribution of Partnership Income and Losses
 A partnership’s income and losses can be distributed
according to whatever method the partners specify in the
partnership agreement.
– If the agreement does not specify this, the partners
share income and losses equally.
– Income in a partnership normally has three components:
 Return to the partners for the use of their capital (called
interest on partners’ capital)
 Compensation for services the partners have rendered
 Other income for any special contributions individual partners
may make to the partnership or for risks they may take
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Stated Ratios
 One method of distributing income and losses is to
give each partner a stated ratio of the total
income or loss.
– If each partner is making an equal contribution to the
firm, each can assume the same share of income and
losses.
– An equal contribution does not necessarily mean an
equal capital investment, because one partner may be
devoting more time and another partner more capital.
– If the partners contribute unequally to the firm, unequal
stated ratios can be appropriate.
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Capital Balance Ratios
 Income and losses may be distributed according to
capital balances.
 The ratio used may be based on each partner’s
capital balance at the beginning of the year or on
the average capital balance of each partner
during the year.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Salaries, Interest, and Stated Ratios
 To make up for unequal contributions to a firm, a
partnership agreement can allow for partners’
salaries, interest on partners’ capital balances, or
both in the distribution of income.
– Salaries and interest of this kind are not deducted as
expenses before the partnership income is determined.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Dissolution of a Partnership
 Dissolution of a partnership occurs whenever there is a
change in the original association of partners.
– When a partnership is dissolved, the partners lose their
authority to continue the business as a going concern.
– This does not mean that the business operation
necessarily is ended or interrupted, but from a legal
standpoint, the separate entity ceases to exist.
– The dissolution may take place through the admission of
a new partner, the withdrawal of a partner, or the
death of a partner.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Admission of a New Partner
 The admission of a new partner dissolves the old
partnership because a new association has been
formed.
– Dissolving the old partnership and creating a new one
requires the consent of all the original partners and the
ratification of a new agreement.
– An individual can be admitted to a partnership in one
of two ways:
 Purchasing an interest in the partnership from one or more of
the original partners
 Investing assets in the partnership
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Bonus to the Old Partners
 A new investor is sometimes willing to pay more
than the actual dollar interest he or she receives in
the partnership.
 The excess of the payment over the interest
purchased is a bonus to the original partners.
– The bonus must be distributed to the original partners
according to the partnership agreement or, if the
agreement does not cover the distribution of bonuses, in
accordance with the method for distributing income and
losses.
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Bonus to the New Partner
 A partnership might want a new partner for
several reasons.
– A partnership in financial trouble might need additional
cash, or the partners might want to expand the firm’s
markets and need more capital.
– The partners might also know a person who would
bring a unique talent to the firm.
– Under these conditions, part of the original partners’
capital may be transferred to the new partner’s
Capital account as a bonus.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Withdrawal of a Partner
 Generally, a partner has the right to withdraw
from a partnership in accord with legal
requirements.
– The partnership agreement should describe the
procedures to be followed, including:
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Whether an audit will be performed
How the assets will be reappraised
How a bonus will be determined
By what method the withdrawing partner will be paid
– A partner can withdraw from a partnership in one of
several ways.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Withdrawal Not Equal to Capital Balance
 A partner’s withdrawal is not always equal to the that
partner’s capital account.
– When a withdrawing partner removes assets that are
less than his or her capital balance, the equity that the
partner leaves in the business is divided among the
remaining partners according to their stated ratios.
– When a withdrawing partner takes out assets that are
greater than his or her capital balance, the excess is
treated as a bonus to the withdrawing partner. The
remaining partners absorb the bonus by reducing their
capital accounts according to their stated ratios.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Death of a Partner
 When a partner dies, the partnership is dissolved
because the original association has changed.
– Normally the books are closed, and financial
statements are prepared to determine the capital
balance of each partner on the date of death.
– The remaining partners may purchase the deceased’s
equity, sell it to outsiders, or deliver certain business
assets to the estate of the deceased partner.
– If the firm intends to continue, a new partnership must
be formed.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Liquidation of a Partnership
 The liquidation of a partnership is the process of
selling enough assets to pay the partnership’s
liabilities and distributing any remaining assets
among the partners.
– Liquidation is a form of dissolution.
– As the assets of the business are sold, any gain or losses
should be distributed according to the stated ratios.
– As cash becomes available, it must be applied first to
outside creditors, then to loans from partners, and
finally to the partners’ capital balances.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Limited Partnerships
 A limited partnership (LP) is a special type of
partnership that, like corporations, confines the
limited partner’s potential loss to the amount of his
or her investment in the business.
– Under this type of partnership, the unlimited liability
disadvantage can be overcome.
– Usually, the limited partnership has a general partner
who has unlimited liability but allows other partners to
limit their potential loss.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Joint Ventures
 A joint venture is an association of two or more
entities for the purpose of achieving a specific
goal, such as the manufacture of a product in a
new market.
– Most joint ventures have an agreed-upon limited life.
– Profits and losses are shared on an agreed-upon basis.
– Joint ventures frequently take the form of partnerships
between two or more corporations and other investors.
– They are often used by U.S. companies that want to
make investments abroad.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Companies That Look Like Partnerships
 S corporations—corporations that U.S. tax laws treat as
partnerships
– Unlike normal corporations, they do not pay federal income taxes.
– They have a limited number of stockholders, who report the income
or losses on their investments in the business on their personal tax
returns.
 Limited liability company (LLC)—companies whose
members are partners, but their liability is limited to their
investment in the business
 Special-purpose entities (SPEs)—firms with limited lives
that a company creates to achieve a specific objective,
such as raising money by selling receivables
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.