Financial Accounting 3 [FA3]
Module 1: Partnership equity accounting
Overview
In FA3, liability and equity issues dominate your in-depth study of the financial reporting model. This
module addresses equity accounting issues in the context of a partnership. Partnerships are often less
complex than corporations, but can have some interesting twists. This module reviews the basic legal
structure of a partnership and explores various accounting issues such as partnership formation, dissolution,
profit distributions, and admission and retirement of a partner. Computer activities cover the distribution of
partnership income and liquidation using a spreadsheet program. The module concludes with a description of
ethical accounting policy choice and an introduction to case analysis. You practise the case analysis
approach introduced in this module as you work through the course.
Since many small businesses are organized as partnerships, this module is very practical if you deal with
small businesses on a day-to-day basis.
Test your knowledge
Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.
Learning objectives
1.1
Describe the conceptual nature of ownership interests. (Level 2)
1.2
Explain the rights and obligations of a partner and the concept of mutual agency. (Level 2)
1.3
Explain how a partnership is created and dissolved. (Level 2)
1.4
Compare and contrast the elements of a general partnership and a limited partnership. (Level 2)
1.5
Account for the creation of a partnership and its ongoing operations, including the distribution of
net income (loss) among the partners. (Level 1)
1.6
Account for admission, retirement, and withdrawal or death of a partner. (Level 1)
1.7
Account for the liquidation of a partnership. (Level 2)
1.8
Prepare, in good form, the financial statements for a partnership. (Level 1)
1.9
Explain the importance of accounting information and policy choice in contracting situations and
describe some typical motivations for accounting policy choice. (Level 1)
1.10
Perform a simple case analysis: recognize the problem, identify and analyze policy choice
alternatives, and provide an ethical recommendation. (Level 1)
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1.1 Theoretical foundation
Learning objective
Describe the conceptual nature of ownership interests. (Level 2)
LEVEL 2
Partnerships
While corporations are the dominant form of organization for business activity in North America, many start
out as partnerships or sole proprietorships. Other businesses are required to operate as sole proprietorships or
partnerships because of the nature of their operations. This module critically analyzes accounting for
ownership interests in partnerships.
In many ways, the issues surrounding partnerships are identical to the issues related to corporations. Owners
create the entity and provide initial capital. Ownership interests change as profits are earned and are
distributed, increase as owners invest additional capital, and decrease as capital is withdrawn. However,
since the legal form of a partnership is different from that of a corporation, the accounting rules are also
different. Some situations can only occur in a corporation — for example, a partnership cannot issue stock
dividends. Other issues, such as profit allocations to individual owners, are unique to partnership accounting.
Nature of ownership interests
Business entities raise capital primarily from two sources: lenders and equity investors. Both expect a return
from the entity — interest (for debt) or profit distributions (for equity), followed by eventual principal
repayment (for debt) or return of equity capital.
Ownership theories attempt to describe the relationship between the business entity and the owners of the
entity and other stakeholders — groups who have a vested interest in the entity's well-being and continued
existence. Ownership theories are described as normative theories; they are based on standards or norms.
They explain how owners' equity and income could or should be measured and reported rather than how they
are reported.
Proprietary view
The proprietary view of an entity assumes that the firm and its owners are virtually one and the same;
creditors are outsiders. This is a narrow view of the firm's activities and costs, focusing on the equity
investor's perspective. Equity is defined as the residual interest in net assets. The accounting equation is
Assets – Liabilities = Equity
According to this view, the components of net income would include expenses for wages, interest, and taxes,
but would not include distribution of profits to equity holders. Such profit distributions are the return on
equity investment.
In a partnership, there is no legal distinction between a partner and the partnership. This is the ultimate
application of the proprietary view. The partners experience the risks and rewards of the ownership of net
assets, and they benefit when operations are profitable. (A partnership is also an interesting application of the
separate entity assumption: legally, a partnership is not a separate entity, but it must be accounted for as if it
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were separate and distinct from the partners personally.)
Entity view
In contrast to the proprietary view, the entity view assumes that the firm has a separate existence apart from
all groups of stakeholders. This is a broad view of the firm's activities and costs; it includes the perspective
of all interested parties. Creditors, employees, governments, and owners have separate rights and interests in
assets and operations. The accounting equation is
Assets = Total equities (Liabilities + Equity)
Equity investors do not "own" owners' equity, but have the residual claim to assets after other stakeholders
are satisfied.
According to this theory, operations generate an operating income, which is then used to satisfy the claims of
all stakeholders. Wages, interest, taxes, and profit distributions are all viewed as payments with equivalent
status.
The difference between the proprietary view and the entity view is most clearly understood by contrasting an
income statement (statement of operations) and a statement of retained earnings (statement of distribution of
earnings) consistent with each view. See Exhibit 1.1-1 below.
Note:
The correct use of accounting terms is an important part of your learning in this course. You will also learn,
however, that there are several sources of authority for the "language of accounting."
An example of variations in terminology is the use of the term "income statement." These module notes and
the textbook that accompanies them use the term "income statement." However, the term "statement of
income," which is used in practice and in the Model Financial Statements produced by CGA-Canada, and the
term "statement of earnings," which some academics prefer, are also acceptable. Either term will be
acceptable in assignments or examinations.
Exhibit 1.1-1: Contrast between the proprietary view and the entity view
Proprietary view
Income statement year ended
December 31, 20X1
Sales
Cost of sales
Other expenses
Wages expense
Interest expense
Tax expense
Net income
Entity view
Statement of operations year ended
December 31, 20X1
$ 5,600
(2,900)
(1,000)
(400)
(200)
(300)
$ 800
Sales
Cost of sales
Other expenses
Operating income
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$ 5,600
(2,900)
(1,000)
$ 1,700
Financial Accounting 3 [FA3]
Statement of retained earnings year ended
December 31, 20X1
Opening retained earnings
Plus: Net income
$800
Less: Dividends
(250)
Closing retained
earnings
$ 2,100
550
$ 2,650
Statement of distribution of earnings year ended
December 31, 20X1
Opening retained earnings
Plus: Operating income
Less: Distribution to stakeholders
•
•
•
•
employees
creditors
governments
equity investors
$ 2,100
$ 1,700
(400)
(200)
(300)
(250)
Closing retained earnings
550
$ 2,650
Exhibit 1.1-1 uses a corporation's financial statement format for both alternatives: distributions of profits are
called dividends, and capital is divided into share equity and retained earnings. These accounts have different
labels when accounting for a partnership (for example, one equity account summarizes both initial
investment and retained profits, profit distributions are not called dividends). Don't dwell on these
differences now. Focus instead on the general placement of payments to stakeholders.
Which view is more appropriate?
The proprietary view is consistent with the traditional income statement because all groups except owners
are viewed as outsiders, and all charges relating to outsiders are on the income statement. However, take a
moment to consider the entity view. Doesn't it make sense to acknowledge that employees, governments, the
general public, and so on, have a vested interest in the firm?
Which view is closer to reality? Which view better represents the ethical responsibilities of the firm?
The answers to these questions depend on the situation. In many instances, liabilities are clearly obligations
to outsiders, and the people who invest equity capital actually control the firm's operations. This is consistent
with the proprietary view. In other cases, creditors or employees may have significant influence over the
operation of the firm. This is consistent with the entity view.
In some large corporations, it is easy to see the application of the entity view; owners really are outside
stakeholders who must be satisfied (compensated) for their investment and risk by an autonomous entity —
the company. This argument is far more difficult to make for a partnership, since the partners are usually
principals involved in the day-to-day operation of the business. Conceptually, the interests of the partners
and the partnership are indivisible, and the proprietary view is appropriate.
In the case of the firm's ethical responsibilities, again, the answer is situational. The entity view certainly
brings many more interests into play, but there is no reason ethical responsibilities would not be addressed
from a proprietary perspective. Shareholders are motivated to address concerns that serve their legitimate
long-term interests without taking advantage of other parties (government, employees, and so on). Based on
the proprietary view, one acts ethically by staying within ethical limits or boundary conditions. As long as
one stays "within bounds," one is ethically free to select from available options.
The proprietary and entity views of ownership interest reflect an important division in business ethics: for
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whose benefit is the business run? Although they are not assigned as part of this course, you can find some
related readings in this area in the Ethics Readings Handbook, Unit B2.
1.2 Nature of a partnership
Learning objective
Explain the rights and obligations of a partner and the concept of mutual agency. (Level 2)
Required reading
Hilton & Heraulf, "Accounting for Partnerships," Bonus Chapter 15 in Modern Advanced Accounting
in Canada, Fourth Edition (Toronto, Ontario: McGraw-Hill, 2005), page 2 (Level 2).
Reading 1.2-1, "Sole Proprietorships and Partnerships (To view the content from this link you must go
on-line.)" The section entitled "The Relation of Partners to One Another" (pages 14-18) is particularly
important because it outlines sections of the Partnership Act that deal with accounting. (Level 2)
LEVEL 2
Partners as agents
Agency is a legal relationship wherein one person (the agent) represents another (the principal) and can enter
into contracts on behalf of the principal with third parties. Partners have a mutual agency relationship, as
they commit each other to contracts through the partnership.
Legally and ethically, partnerships are trust arrangements. From an ethical (and legal liability) perspective, it
is important to avoid partnerships with untrustworthy people, and it is essential to reciprocate trustworthy
behaviour.
In a long-standing partnership, there should be a good track record of trustworthy behaviour among partners.
In new partnerships, there should be reason to believe that one's partners are trustworthy. Of course, longstanding partners, as well as new partners, can let partners down and take advantage of the trust bestowed in
them.
Because trust is fundamental to partnerships (compared to corporations with limited liabilities), an
accountant has to consider fairness to all when giving advice in a partnership environment.
As an accountant, you are in a position to help people enter, maintain, and leave partnerships. Remember that
unless there is a separate partnership agreement, the provincial Partnership Act will rule. Partners should
carefully work through the implications of the Partnership Act and establish an arrangement that suits their
individual needs.
Accountants are not expected to be able to give expert advice on the interpretation of the Partnership Act or
on all aspects of partnership agreements. However, you must be able to explain the nature of a partnership,
the common legal implications of partnerships, and the accounting implications of the Partnership Act.
Advantages and disadvantages of partnerships
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Some types of endeavours must be carried on through a partnership. For example, legal and accounting firms
in some jurisdictions are, at present, not permitted to incorporate. Because these firms provide professional
services, the legal structure is established to ensure that the partners' personal assets are at risk, or available,
to those who rely on their professional judgment. In other words, the partners cannot hide behind the
"corporate veil" of limited liability. This is one of the ways in which society signals high expectations for
professionals.
Why might some other type of business choose to form a partnership rather than incorporate? There are some
important advantages and disadvantages to each choice:
Partnerships
There may be tax advantages for a partnership; a partnership is not a taxable entity.
Partners pay personal income tax based on their portion of total partnership income, whether
distributed to the partner as a withdrawal or retained in the partnership.
Partners' personal tax rates are low for low levels of income and climb for higher levels of
income. Losses from partnership activities may be netted against personal income from other
sources.
A partnership is easier to form than a corporation, with lower start-up costs.
A partnership is subject to less government regulation and fewer reporting requirements than a
corporation.
It may be difficult to transfer ownership interests.
Mutual agency applies.
Personal liability is unlimited.
The partnership dissolves at the death of one partner.
Corporation
The liability of shareholders in a corporation is limited to their investment.
The life of a corporation is legally unlimited.
Ownership of the corporation is easily changed by selling shares.
There may be tax advantages. A corporation is a taxable entity; corporations pay tax on taxable
income, if any, after salary is paid to owner-employees. Corporate tax rates are constant over wide
income levels and may be higher or lower than personal rates.
Owners pay tax only on salary actually received.
Distributions of net income as dividends are taxable income to owners, but not tax deductible for
the corporation.
The corporation is more difficult to form and has more subsequent reporting obligations.
Shareholders cannot commit the organization or other shareholders to contracts.
1.3 Creation and termination of a partnership
Learning objective
Explain how a partnership is created and dissolved. (Level 2)
Required reading
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Review Reading 1.2-1, "Sole Proprietorships and Partnerships (To view the content from this link you
must go on-line.)," pages 7-8 and 18-20 (Level 2)
LEVEL 2
Review the material indicated above from Reading 1.2-1 to understand the importance of a partnership
agreement and what happens when the partnership is terminated.
Because the provincial Partnership Act will apply in all matters not set out in a formal partnership
agreement, and because oral agreements are vulnerable to the shortfalls of memory and subjective
interpretation, an agreement drafted with expert assistance is advisable. The reading provides a checklist of
matters that should normally be covered in such an agreement. The agreement should also include provisions
for termination of the partnership, including
when the partnership can be terminated
how much notice is required
whether the remaining members will continue as partners
how the retiring (or departing or deceased) partner's share is to be valued
how the continuing partners will arrange to buy out this share
1.4 General and limited partnership
Learning objective
Compare and contrast the elements of a general partnership and a limited partnership. (Level 2)
Required reading
Reading 1.2-1, "Sole Proprietorships and Partnerships (To view the content from this link you must go
on-line.)," pages 12-13 and 21 (Level 2)
LEVEL 2
Limited partnership
Many professional practice firms in the field of public accounting are organized as limited liability
partnerships (LLP's). Limited partnerships have been a popular vehicle for financing real estate projects
because they can provide tax advantages to limited partners. Specifically, a limited partner provides capital
for a real estate project that is (hopefully) in a break-even position in terms of operating cash flow. The
income statement shows losses, though, because of non-cash charges — amortization (or, for tax purposes,
tax amortization, called capital cost allowance). The limited partners can claim their share of these losses
against other earned income on their personal tax returns. Thus, part of the return the limited partners earn on
their investment comes through tax relief. Of course, if the real estate project goes sour, the limited partners
lose their invested capital, although none of their personal assets are at risk unless they become active in
management.
Real estate is a volatile industry, and some projects have resulted in the loss of limited partners' capital
investment. Have you ever observed that some investors take on great financial risk to reduce current taxes?
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Investment opportunities must be carefully evaluated.
1.5 Partnership contribution and profit distribution
Learning objective
Account for the creation of a partnership and its ongoing operations, including the distribution of net
income (loss) among the partners. (Level 1)
Required reading
"Accounting for Partnerships," pages 2-5 (Level 1)
LEVEL 1
Overview of partnership profit allocation
For partnerships, allocation of profit is a major — and unique — accounting problem. There are an infinite
number of ways that profits and losses can be allocated between partners. The accountant or lawyer should
make sure that partners come to an explicit agreement on how their earnings are to be split. The accountant
cannot decide this issue — the partners must form an agreement. Otherwise, the relevant Partnership Act
will speak for them — a solution that may make no one happy.
Allocations can become very complex very quickly, especially when a number of factors enter into the
picture, such as the size of partner investment, degree of involvement, and so on. If the partners are in
agreement with respect to these key variables, fairly simple profit allocations will seem fair. If not, the
complexities must be worked out. Accountants are usually involved in this process.
Computer activity 1.5-1: Allocation of net income to partners
The required reading explains the unique partnership accounts and provides examples of allocation of net
income. The distribution of income and bonuses to partners in a partnership can pose some interesting
computational problems. In this computer activity you use a worksheet to calculate a partnership income
distribution.
Material provided
The file FA3M1P1 contains two worksheets:
M1P1 — a partially completed worksheet to calculate partnership profit distribution
M1P1S — solution for the worksheet M1P1
Description
Malinski and Chong are partners in the accounting practice of Malinski & Chong, Certified General
Accountants. Their capital account balances on January 1, 20X5, were $60,000 and $30,000, respectively.
Their partnership agreement stipulates the following method of distributing partnership profits:
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To Malinski:
salary of $36,000
5% interest on beginning capital balance
60% of the residual profit or losses after total partner salaries and interest are paid
To Chong:
salary of $56,000
5% interest on beginning capital balance
40% of the residual profit or losses after total partner salaries and interest are paid
Required
The partnership net income before partner salaries and interest is $180,000. Calculate, using the worksheet
FA3M1P1, the distribution of the 20X5 partnership profits. For each partner, calculate the partnership
income as a percentage of the total profit.
Procedure
Perform the following steps:
1. Start Excel and open the file FA3M1P1. (Before you begin working on the data files in this course,
you must first download them and save them to your hard drive. Click the data files link in the
navigation pane, then follow the instructions for downloading and saving the files.)
2. Click the sheet tab for M1P1.
3. Observe rows 9 to 16 in the data table. The schedule of partnership profit distribution starts in row 21.
This schedule is blank, except for column and row labels.
Enter the appropriate formulas in rows 28 to 34, where required.
Enter a formula in cell D32 to perform a cross-adding IF statement as a further test of accuracy. (In
other words, if the sum of cells B32 to C32 equals the sum of cells D28 to D30, the result of the sum
of cells B32 to C32 is displayed. Otherwise an error function is displayed.)
4. Save the file.
5. Print a copy of the completed worksheet.
6. To view the solution, click the sheet tab M1P1S. This worksheet contains the results you should have
obtained if you have completed the worksheet correctly. If you had different results, make the
appropriate changes.
1.6 Admission, retirement, and withdrawal or death of a partner
Learning objective
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Financial Accounting 3 [FA3]
Account for admission, retirement, and withdrawal or death of a partner. (Level 1)
Required reading
"Accounting for Partnerships," pages 5-12 (Level 1)
LEVEL 1
Admitting a new partner
Whenever a new partner is admitted to an existing partnership, the old partnership is technically dissolved
and a new one is formed. Although there are legal matters that must be considered, as long as the partnership
agreement provides for continuity, the day-to-day operations of the firm are rarely affected. The old
partnership agreement should be amended or a new one drawn up to reflect the change in the partnership. All
the matters addressed previously, such as division of profit and loss, should be discussed and agreed on
among the partners when amending or redrafting the partnership agreement.
Exhibit 1.6-1 summarizes the two general bases on which a new partner may be admitted to a firm, and
alternatives to account for each.
Exhibit 1.6-1: Summary of alternative bases of admission
Goodwill
There are several ways the admission of a partner can be accounted for. One of these alternatives results in
goodwill recognition.
Recording goodwill from the admission of a partner does not necessarily provide meaningful information to
financial statement users, since it inflates assets and equities by including an intangible asset with an
uncertain cost base on the balance sheet. Consequently, many accountants prefer to treat any excess paid by a
new partner as a bonus to the old partners.
Goodwill must be evaluated annually for possible impairment of value. Goodwill is not amortized, but is
written down if impaired. Impairment is uncertain and calls for estimation. Any impairment loss is a charge
against income and will flow through the capital accounts on the allocation of income. If the partnership
were liquidated, any remaining goodwill would probably be written off immediately since it would not have
any realizable value on liquidation.
Retirement of a partner
On retirement, withdrawal, or death, a partnership is legally dissolved and all the partners must be paid out.
The partnership agreement should specify the process on retirement, withdrawal, or death, especially if the
surviving partners wish to continue in business together.
See Exhibit 1.6-2 for a summary of two alternate methods of retirement.
Exhibit 1.6-2: Two alternate methods of retirement
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1.6 Admission, retirement, and withdrawal or death of a partner - Content Links
Exhibit 1.6-1: Summary of alternative bases of admission
1. The new partner purchases all or part of the interest of one or more of the existing partners. On
this basis, the new partner pays the old partner(s) directly, and no new assets come into the firm.
Accounting basis:
Method A: transfer portion of existing book value
Method B: recognize goodwill based on price paid, then transfer portion of revised book value
Examples of these alternatives are on pages 6-7 of the text. Method A is the most commonly found in
practice.
2. The new partner invests in the existing business by making a payment to the partnership. On this
basis, the assets of the firm will increase.
Accounting basis:
Bonus method: New partner is given a proportionate interest in book value and assets invested
above/below this amount are "bonused" (given or taken away from) the existing partners.
Asset revaluation method: New partner investment is used to imply a value for the partnership and
existing assets are written down (or up) with the resulting loss or gain charged or credited to the
existing partners. When assets must be written up, goodwill is often recognized.
Examples of these alternatives are on pages 7-11. The bonus method is the most commonly found in
practice, except when the price paid by the new partner implies that assets are impaired, in which case
assets will be written down.
Exhibit 1.6-2: Two alternate methods of retirement
The retiring partner will receive cash (or a promissory note) from the partnership; its net assets will decline.
The alternatives are:
Bonus method: The difference between the book value of the old partner's capital accounts and the
payment recorded is bonused to (or taken away from) the old partners.
Asset revaluation method: The price paid to the old partner is used to imply a value for the
partnership and existing assets are written down (or up) with the resulting loss or gain charged or
credited to both the old and new partners. When assets must be written up, goodwill is often
recognized.
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1.7 Liquidation of a partnership
Learning objective
Account for the liquidation of a partnership. (Level 2)
Required reading
"Accounting for Partnerships," pages 12-16 (Level 2)
LEVEL 2
Liquidation of a partnership means that the business comes to an end. The process of liquidation entails the
following steps:
1. Realization (sale) of assets. All non-cash assets should be converted to cash. For example, amounts
owing to the partnership should be collected, and other assets, such as inventory or capital assets,
should be sold. The realization should be carried out with care to ensure that the maximum amount is
received on the disposition of the assets.
2. Allocation of gains and losses. Any gains or losses realized on the disposition of assets should be
allocated to the partners in their profit-and-loss-sharing ratio. The importance of allocating these gains
and losses to the partners before any cash is distributed to them cannot be overemphasized.
3. Payment to creditors. Upon liquidation, the creditors of the firm rank ahead of the partners; therefore,
creditors must be paid in full before any distribution is made to partners.
4. Payment of loans from partners. If the partners have made loans to the firm, they rank behind the
creditors in payment preference. However, partners' loans must be settled before any distributions with
respect to equity are made to partners.
5. Distribution of remaining assets to partners. After the first four steps have been carried out, the
remaining assets may be distributed to the partners. If loans have been made to partners, the balance
due to the partnership may be offset against the indebted partner's capital account before final
distribution of equity is made.
Insolvency
On liquidation, a partnership may be solvent or insolvent. In an insolvent partnership, partnership liabilities
exceed realizable assets. Accounting for an insolvent partnership is beyond the scope of this course.
Liquidation of a solvent partnership
In a solvent partnership, one of two situations can exist:
The equity of each partner can absorb any losses on realization. This situation is illustrated in the
required reading (pp. 12-14) and in the computer activity you will work through in the next section.
or
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The equity of one or more partners is not sufficient to absorb the losses. This situation is illustrated in
the required reading (p. 14-15) and in Activity 1.7-1 below.
Activity 1.7-1: Equity of one partner is insufficient to absorb losses
Able, Barker, and Chu are partners in a firm that is about to be liquidated. The partners have been sharing
profits and losses equally. The balance sheet prior to liquidation is as follows:
Able, Barker, and Chu Partnership
Balance sheet
as of liquidation date
Assets
Cash
Other assets
$ 8,000
67,000
_______
$75,000
Liabilities and partners' equity
Accounts payable
$ 22,000
Able, capital
19,000
Barker, capital
25,000
Chu, capital
9,000
$75,000
The non-cash assets are sold for $22,000. Divide the loss of $45,000 among the partners and assume Chu
pays in money to cover his debit balance.
Complete a schedule of partnership liquidation.
Profit-and-loss ratio
Assets
Liabilities
Partners' equity
Cash
Non-Cash Creditors A Capital B Capital C Capital
1/3
1/3
1/3
Pre-liquidation balances
Realization and loss
$________ $________ $________ $________ $________ $________
$________ $________ $________ $________ $________ $________
Balances
Payment to creditors
$________ $________ $________ $________ $________ $________
$________ $________ $________ $________ $________ $________
Balances
Payment from Chu
Distribution to Able and Barker
$_______ $_______ $_______ $_______ $_______ $_______
$________ $________ $________ $________ $________ $________
$________ $________ $________ $________ $________ $________
Balances
$_______ $_______ $_______ $_______ $_______ $_______
Solution
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Computer activity 1.7-1: Sample partnership liquidation
Description
Assume that Belanger, Thibault, and Smithson have decided to liquidate their partnership as at December 31,
20X8. They have been sharing profits and losses in the ratio of 5:3:2. The balance sheet of the partnership
after closing the books on December 31, 20X8, is as follows:
Belanger, Thibault, and Smithson Partnership
Balance sheet
December 31, 20X8
Assets
Cash
Inventory
Other assets
$ 10,000
20,000
70,000
$100,000
Liabilities and partners' equity
Accounts payable
$ 13,000
Belanger, capital
34,000
Thibault, capital
23,000
Smithson, capital
30,000
$100,000
Required
During liquidation, $15,000 is realized on the inventory and $41,000 on the other assets. The partners will
share the $34,000 loss (proceeds of $56,000 realized versus cost of $90,000) on realization in their profitand-loss ratio. The outside creditors will be paid, and the remaining cash will be distributed to the partners.
Using worksheet FA3M1P2, calculate the liquidation of the partnership's assets and the final distribution to
the partners. The liquidation schedule is shown as a worksheet.
Material provided
The file FA3M1P2 contains two worksheets:
M1P2 — a partially completed worksheet to calculate the schedule of partnership liquidation
M1P2S — solution for worksheet M1P2
Procedure
1. Start Excel and open the file FA3M1P2.
2. Click the sheet tab for M1P2.
3. Observe that rows 7 to 26 contain the data table. The schedule of liquidation starts in row 32. This
schedule is blank, except for column and row labels.
4. Enter the appropriate formulas or cell references in rows 39, 41, and 42. In row 42, cash increases and
assets decrease. The loss (decrease in assets versus increase in cash) is allocated to each partner using
his or her ratio. Write formulas to reflect these facts.
5. Rows 44, 47, and 50 are simply sums of the previous two rows. Enter the appropriate formula in these
rows.
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6. Enter the payment to creditors in row 45 using the appropriate formula. Cash and liabilities decrease.
7. Row 48 is used to calculate the distribution to the partners. Enter the necessary formulas in row 48.
Cash and equity decrease.
8. Save the file.
9. Print a copy of the completed worksheet.
10. To view the solution, click the sheet tab M1P2S. This worksheet contains the results you should obtain
if you have completed the worksheet correctly. If your results were different, make the appropriate
changes.
Instalment liquidation
Note: Extend your knowledge background information is not examinable.
1.7 Liquidation of a partnership - Content Links
Activity 1.7-1 solution
Dividing the loss of $45,000 among the partners creates a $6,000 debit balance in Chu's capital account, as
shown in the following schedule of liquidation.
Able, Barker, and Chu Partnership
Schedule of partnership liquidation
Assets
Liabilities
Partners' equity
Cash Non-cash Creditors A Capital B Capital C Capital
Profit-and-loss ratio
1/3
1/3
1/3
Pre-liquidation balances $ 8,000 $67,000 $(22,000) $(19,000) $ (25,000) $(9,000)
Realization and loss
22,000 (67,000)
—
15,000
15,000 15,000
Balances
$30,000 $
— $(22,000) $ (4,000) $ (10,000) $ 6,000
Payment to creditors
(22,000)
—
22,000
—
—
—
Balances
$ 8,000 $
— $
— $(4,000) ($10,000) $6,000
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Chu has an obligation to pay the partnership $6,000; otherwise, Able and Barker will receive less than their
equity in the partnership. If Chu is solvent and pays $6,000, the liquidation schedule would be completed as
follows:
Balances
Payment from Chu
Cash
$ 8,000
6,000
$14,000
A
$(4,000)
—
$(4,000)
B
$(10,000)
—
$(10,000)
C
$ 6,000
(6,000)
—
Distribution to
Able and Barker
Balances
(14,000)
4,000
10,000
—
$
—
$
—
$
—
$
—
If Chu is insolvent and thus unable to pay the $6,000, the loss should be charged to Able and Barker in their
proportionate profit-and-loss ratio. Since each had a 1/3 interest in profits, they have an equal (1/2) interest
once C drops out. This is the scenario that is illustrated in the chapter material, on pages 14-15.
Balances
Loss on uncollectible amount
due from Chu
Distribution to Able and Barker
Balances
Cash
$8,000
A
$(4,000)
B
$(10,000)
C
$(6,000)
—
$8,000
(8,000)
3,000
$(1,000)
1,000
3,000
$ (7,000)
7,000
(6,000)
—
—
$
$
$
—
—
—
$
—
Instalment liquidation
It can take considerable time to fully liquidate a partnership, and the partners may well be unwilling to wait
for final liquidation before receiving any payment from the partnership. Instalment payments may be
authorized. However, the danger is that such payments might be excessive, or made to the wrong partner.
This is a high-risk situation!
The partnership must perform a "what-if" calculation that establishes safe payments to each partner. To
establish a safe payment, it is assumed that all remaining assets are disposed of for zero proceeds, and the
remaining partners absorb any partner debit balances.
The text example on pages 16-22 of the bonus chapter "Accounting for Partnerships" illustrates this process.
Also illustrated is a schedule of safe payment, specifying, in advance, who will be entitled to money as
collected. This allows partners to understand their cash flow in advance, and eliminates the need for endless
calculations.
1.8 Financial statement presentation
Learning objective
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Prepare, in good form, the financial statements for a partnership. (Level 1)
LEVEL 1
The disclosure requirements for unincorporated businesses such as partnerships or sole proprietorships are
set out in section 1800 of the CICA Handbook, "Unincorporated Businesses." As in the case of a corporation,
the financial statements of a partnership should include a balance sheet, income statement, and cash flow
statement. However, a partnership will include a "statement of partners' equity," outlining changes in owners'
equity, rather than a statement of retained earnings. This statement must clearly show changes from
investment, drawings, and income earned.
The financial statements of a partnership have to include the names of the partners and the name under which
the business is operated. In recognition of the fact that partners have unlimited liability and the assets of the
partnership are therefore available to the personal creditors of the owners, the CICA Handbook, section
1800.05, requires that appropriate disclosure be made:
It should also be made evident that the business is unincorporated and that the statements do not
include all the assets, liabilities, revenues, and expenses of the owners.
This disclosure is an application of the business entity assumption: the business entity is considered an
accounting unit separate and apart from its owners. The assumption ignores the legal status of the partnership
(not separate and apart from the owners) and the fact that many loans made to a partnership are secured by
the partners' personal assets. A lender would likely ask to see a personal net worth statement (list of
personal assets and liabilities for each partner) in addition to the partnership financial statements.
The CICA Handbook appears to allow the charging of salaries, interest, and other such items paid to partners
against income. Most accountants agree that such items are more appropriately charged against equity
because they represent allocations of income to the partners. If salaries and interest are accounted for as
charges against income, the CICA Handbook, section 1800.07, requires that they be disclosed separately:
Any salaries, interest or similar items accruing to owners ... should be clearly indicated by
showing such items separately either in the body of the income statement or in a note to the
financial statements.
If the financial statements do not reflect charges against income for salaries and other items, this fact should
also be disclosed.
Because a partnership is not a separate entity for income tax purposes, no provision for income taxes should
be made in the financial statements. Disclosure of this fact should be made.
Finally, a statement is required showing the changes in owners' equity, by source, for the period.
Example 1.8-1 shows a sample set of financial statements for a partnership.
Example 1.8-1: Financial statements for a partnership
Dunlaney and Petersen Partnership, Importers
Income statement
year ended December 31, 20X8
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Sales
Cost of goods sold
Gross margin
Operating expenses
Net income
$120,000
72,000
48,000
20,000
$28,000
Allocated as follows:
Dunlaney
$ 10,000
—
5,500
$15,500
Partners' salaries
Interest on capital
Remainder equally
Total
Petersen
$ 5,000
2,000
5,500
$12,500
Total
$ 15,000
2,000
11,000
$28,000
Dunlaney and Petersen Partnership, Importers
Statement of partners' equity
year ended December 31, 20X8
Dunlaney
$15,000
15,500
30,500
(16,500)
$14,000
Capital — January 1, 20X8
Net income for the year
Drawings
Capital — December 31, 20X8
Petersen
$23,000
12,500
35,500
(13,500)
$22,000
Total
$38,000
28,000
66,000
(30,000)
$36,000
Dunlaney and Petersen Partnership, Importers
Balance sheet
December 31, 20X8
Assets
Current
Cash
Accounts receivable
Inventory
$ 8,000
15,000
24,000
47,000
48,000
$95,000
Capital assets (net)
Total assets
Liabilities and partners' equity
Liabilitites
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Current liabilities
Loans payable
$ 29,000
30,000
59,000
Partners' equity
Partners' equity
Total liabilities and partners' equity
36,000
$95,000
Dunlaney and Petersen Partnership, Importers
Note to the financial statements
December 31, 20X8
The accompanying financial statements include only the assets, liabilities, revenues, and expenses of the
partnership carried on under the name of Dunlaney and Petersen Partnership, Importers and do not include
the personal assets, liabilities, revenues, and expenses of the partners. No provision for income taxes has
been made in these financial statements because income of the business is taxable only in the hands of the
partners. No amounts have been charged against income for salaries, interest, or other similar compensation
to the partners.
1.9 Ethical accounting policy choice
Learning objective
Explain the importance of accounting information and policy choice in contracting situations and
describe some typical motivations for accounting policy choice (Level 1)
Required reading
ERH, Unit C3, CGA-Canada's "Code of Ethical Principles and Rules of Conduct" (Level 1)
Reading 1.9-1, "Extract from Canadian Cases in Financial Accounting" (Level 1)
(For all ethics-related readings in this course, it is assumed that you are already familiar with Section A of
the Ethics Readings Handbook. ERH readings are accessible through the Resources tab. When you read the
Code of Ethical Principles and Rules of Conduct, pay particular attention to sections R100, R200, R300, and
R400, to the first statement of ethical principle, Responsibilities to Society — which emphasizes the
member's obligation to act with "trustworthiness, integrity and objectivity" — and to rule R101,
"Discredit." )
LEVEL 1
As an accountant, you need to be able to choose appropriate financial accounting and reporting policies in a
variety of circumstances. This requires the ability to apply the recognition criteria appropriately, and to
exercise ethical behaviour when making such decisions.
Consider the general problem of accounting policy choice described in Reading 1.9-1. Then consider some
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specific factors that may influence accounting policy choice:
1. Management incentive plans
In many large companies, management remuneration packages provide a salary, cash bonuses based
on net income, and stock incentives based on share price performance. Common shares are offered to
managers based on share price performance to try to align the long-term interests of the firm's
shareholders and its managers. The cash bonus is based on a percentage of income once a target is
reached. Once net income rises above a certain ceiling, no further bonus is paid. This practice provides
a great incentive to keep income between the target and the ceiling. That is, managers of units with
income above the ceiling are motivated to pick accounting policies that carry forward 'surplus'
earnings to the next period.
2. Lending covenants
Long-term lending contracts often include covenants to protect the lender from observable actions by
the borrower that are against the lender's interests, such as additional borrowing or excessive dividend
payments. Covenants are often based on ratios such as working capital, times interest earned, debt to
equity, and so on. Violation of a debt covenant puts the borrower in default of the loan contract; the
lender can demand repayment or, more commonly, renegotiate terms and conditions, including interest
rate charges. Firms affected by these covenants try to select accounting policies that improve critical
ratios.
3. Political motivation
Is it possible to report too much income? If a firm is politically visible (usually because of size, the
nature of the business, or because of a government-awarded monopoly), high levels of return are
potentially undesirable. High profits attract attention and may create enough dissatisfaction and
political unrest to cause the government to regulate some aspect of the business or intervene in another
fashion. Such firms would rather minimize reported accounting income at levels that provide (barely)
satisfactory levels of return to creditors and investors.
4. Taxation
Reduction of income to lower tax payments is an obvious motivation for accounting policy choice.
Remember, though, that there are extensive provisions in the Income Tax Act requiring the use of
certain accounting methods for tax purposes, regardless of the accounting policy choice made for
external reporting; thus, firms may have little room to manoeuvre.
5. Contracts
Legal agreements often refer to data (numbers) in (audited or unaudited) financial statements. For
instance, an agreement may specify that "net income" is to be allocated in a variety of ways or that
"book value" of equity (or a multiple thereof) is to be used to establish a buy-out price when a partner
retires or a new partner arrives. In these circumstances, there is considerable contractual motivation to
manipulate income and book value.
How can the contracting parties make sure that manipulation does not lead to inappropriate valuation?
Specifying that GAAP must be followed is a first step. However, there are areas of accounting policy
where GAAP leaves room for choice.
For legal contracts, it is wise to establish explicit accounting policies that govern critical financial
statement elements and to allow no changes unless all parties agree. For partnership agreements, it is
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also wise to establish an arbitration process to follow in the event of a dispute, to avoid long, costly,
and potentially embarrassing legal actions.
Policy choice and ethical considerations
How do accountants choose accounting policies? First, the accountant must consider the generally accepted
accounting principles that govern the firm's specific circumstances. Fair presentation is part of GAAP. In
many cases, GAAP offers no leeway and the GAAP-dictated policy is the only choice.
If GAAP allows choice, the accountant must determine which alternative suits financial statement users the
best. Before making a recommendation, the accountant must consider not only the "insiders" but all
stakeholders. An ethically defensible resolution is not necessarily an ideal or perfect solution, but represents
a "good enough" solution. (See Unit A8 in the ERH if you would like to refresh your memory about this
decision-making process.)
Accounting policy choice can seem manipulative at times. The accountant must apply a personal and
professional code of ethics and understand when to "draw the line."
There are many contemporary stories about business failures accompanied by less-than-appropriate choices
of accounting policy. Enron and the like have left permanent scars in the investment community, and have
helped to focus attention on the critical and sensitive issue of policy choice.
Differential accounting
Beginning in 2002, differential accounting became part of Canadian GAAP. Differential accounting applies
to private (not public) businesses if their owners unanimously consent. Thus, a partnership that is not a
public entity can opt for differential accounting if the partners all consent. (A partnership might be a public
entity if it has debt that is publicly traded, or if it is in a regulated industry, deemed to affect the public
interest.)
What is the big deal? Differential accounting allows simpler accounting policies to be chosen in certain areas
with no deviation from GAAP. For partnerships, two main areas are affected:
Subsidiaries and joint ventures may be accounted for with the cost or equity method, rather than
consolidation or proportionate consolidation.
Significant influence investments may be accounted for using the cost method, rather than the equity
method.
These alternate acceptable policies have been determined with reference to the cost/benefit trade-off: The
cost of more complicated accounting policies would not be justified by better decisions made by the users.
Note that partnerships may choose appropriate policies in these areas; they are not required to follow the
differential rules. The GAAP emphasis is on appropriate choice in the circumstances. Of course, the policy
chosen must be disclosed.
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1.9 Ethical accounting policy choice - Content Links
Reading 1.9-1
Extract from Canadian Cases in Financial Accounting
A financial report can be viewed as a method for one group (e.g., a business owner) to communicate with
another (e.g., a chartered bank). The person who receives this communication will use it to make decisions
(e.g., lend money, change interest rates). If financial accounting is seen as having the power to affect
behaviour, it is only natural to expect the preparer to wish to present it in a way that might increase the
likelihood of getting the desired behaviour. This is neither good nor bad, it is merely a factual observation.
Professional accountants have to understand the potential biases in a situation in order to be effective.
In financial accounting, generally accepted accounting principles (GAAP) exist to establish the basic ground
rules. In some instances, they are specific, rule-oriented pronouncements that leave little room for the
exercise of professional judgment. For example, the CICA Handbook sections on earnings per share and
leases are very specific. In other areas, the standards require that circumstances be carefully considered, and
judgment used, when establishing an accounting policy. For example, the accounting policy chosen to
translate the statements of a foreign subsidiary into Canadian dollars depends on Handbook-specified
individual circumstances. In other areas, a variety of accounting policies are acceptable under GAAP, with
few indications of the factors that should dictate choice. For example, inventory costing methods (FIFO,
LIFO, weighted average, and the like) and amortization methods (straight line, declining balance, and so on)
are not narrowed in any directive manner.
How does a professional accountant make decisions when there is choice? If application of certain policies
produces statements that are more suitable for the purpose for which they are intended, then the choice seems
obvious. But "suitability" is subjective. The professional accountant must guard against biasing statements to
attempt to ensure a given outcome. Fair presentation is an overriding concern.
The value of accounting information is partly a function of reliability, of which a major component is
neutrality. Accounting information would soon lose its credibility if it were biased or expected to be biased.
Think of the role of the professional accountant like this: First, to understand the environment,
circumstances, and motivations of the providers (and users) of accounting information who produce (or use)
an accounting policy or a desired policy. Second, to judge the acceptability of a policy in relation to
established standards, a combination of technical knowledge and judgment. Usually, the standards are GAAP
and fair presentation, but in some cases all parties are better served by tailor-made policies. Third, the
accountant must have the ability to implement the policy — the application of technical knowledge.
Source: Carol Dilworth and Joan Conrod, Canadian Cases in Financial Accounting, Second Edition
(Homewood, Illinois: Richard D. Irwin, Inc., 1993), page 1.
1.10 Introduction to case analysis
Learning objective
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Perform a simple case analysis: recognize the problem, identify and analyze policy choice alternatives,
and provide an ethical recommendation. (Level 1)
Required reading
Analyze a case (under the How to tab) (Level 1)
LEVEL 1
One of the most important skills for a professional accountant is the ability to analyze a financial accounting
situation, identify alternatives, and formulate recommendations using ethical, professional judgment. In this
topic, you explore case analysis by writing your own response to a case and comparing it to the suggested
solution and to a sample student response. Before you begin, you should review the required reading, and the
case analysis section of the Introduction to FA3, particularly Preparing a case analysis report. The marking
key in the solution to Activity 1.10-1 will help you understand the expectations for case analysis.
Test your ethics and practise performing a case analysis by reading the case scenario in Activity 1.10-1 and
working through an analysis to formulate an appropriate response. (Take the time to write an appropriate
response before reading the suggested solution. By doing so, you will learn more from this exercise.)
Activity 1.10-1: Sample case analysis — Chan and Baaz
Sandy Chan and Philip Baaz have operated an import and sales partnership for 15 years. They import a
variety of food products into Canada and distribute them to small specialty grocery stores and some larger
chain stores in southern Ontario. At times, they have made profits of up to $150,000 per year (profits and
losses are split equally); however, the lingering recession has hurt their business and profits were only
$80,000 last year. Philip Baaz, in his late 50s and financially secure, has decided to retire. Tired of Canadian
winters, he has retired to Mexico and left the partnership in Sandy Chan's hands.
Sandy Chan is in his mid-40s, and through a series of personal tribulations, is nowhere near as financially
secure as his partner. He does not have the resources to buy out Baaz personally, and there is no cash in the
partnership at the moment. Assets consist of receivables and inventory. A significant downsizing would be
required to buy out Baaz with a payment from the partnership right now. Baaz, however, is in no hurry for
his money. The partners have agreed that for the rest of this year, Chan will operate the business alone, and
profits will be split evenly. At year end, Baaz will leave the partnership and take back a five year note
payable for the book value of the balance in his partnership account, which would include his share of
current year profits. While Baaz would not have helped generate this year's profits, this allocation was agreed
to be fair due to his past contributions.
At the end of the year, you have arrived to prepare the financial statements for the year. You are a
professional accountant. The partnership has been your client for 15 years (since the partnership was
formed), and you are on excellent terms with the partners and their staff. You have met with the bookkeeper
and obtained the following information:
1. Since Chan and Baaz have personal contact with their customers, the partnership has always
established an allowance for doubtful accounts based on specific identification of problem accounts.
This year, the allowance has been based on a percentage of sales — at a rate that is double the
historical trend. The bookkeeper has assured you that most receivables are current, but "there's a
recession on and we expect some problems to crop up."
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2. During the year, a sizeable amount of inventory acquired during the last two years was written off. The
bookkeeper explained that the product was not perishable, that it was still in the warehouse but very
slow moving, and that Chan had given up trying to sell it.
3. A personal computer and laser printer were acquired for office use late in the year. Consistent with
prior policy, a full year's amortization was booked in the year of acquisition. Previous office
equipment has been amortized using the straight-line method, but the computer is being amortized on a
40% declining balance scheme "because of the risk of technological obsolescence."
You have a meeting scheduled with Chan this afternoon to discuss accounting policies and operating results;
Baaz is still in Mexico.
Required
Write a brief report on which to base your discussion with Chan. Outline the issues and alternatives, then
write an analysis of each issue and your recommendation. Write a separate note that states your likely course
of action should Chan not accept your recommendations.
As you consider this scenario, ask yourself the following questions:
1. How do the two partners' motives differ in this situation?
2. Whose interests are you protecting?
3. If you anger Chan, will you lose a client? Should this be your primary — or secondary — motivation?
4. What are the accounting issues?
5. For each issue, is the accounting policy chosen acceptable?
Under what circumstances would it be acceptable?
What extra information would you like to have?
Are Chan's concerns legitimate? How can you fix the problem?
What do you recommend?
6. What are you going to do if Chan doesn't like your recommendations?
Disclose policies in the notes?
Contact Baaz?
Resign?
Attempt to arbitrate the problem?
Solution
1.10 Introduction to case analysis - Content Links
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Activity 1.10-1: Suggested case analysis solution
Take a look at the suggested solution and the sample student response. Then try to mark your own response
using the key provided following the solution.
Overview
The Chan and Baaz partnership is in the import and sales business and is less profitable now than in the past.
It is in its last year and will become Chan's sole proprietorship next year. Baaz is entitled to half the current
year's profits and his book equity value at the end of the year. Chan has an obvious incentive to minimize
income and net assets in these circumstances. Baaz would be interested in fair evaluation of operating
performance and net assets, and in ensuring that the entity remains viable, since he is not entitled to a payout
for five years.
Issues
The partnership has new/questionable policies for
1. Allowance for doubtful accounts: percentage of sales versus specific identification
2. Write-off of obsolete inventory
3. Amortization policy for new computer equipment
Analysis
1. Allowance for doubtful accounts
An allowance for doubtful accounts must be established, but several approaches to establishing the
appropriate amount are allowed under GAAP. In the past, specific identification has worked well, but
percentage of sales is objective and also acceptable. It is a concern that the percentage chosen for this
year is double the historical experience and that there is no evidence to support the need for a larger
allowance. Vague worries about the recession cannot be allowed to cause a larger expense and lower
assets.
Chan should be asked to prepare an estimate of doubtful accounts based on the same criteria as prior
years, and the allowance should be adjusted accordingly.
On the other hand, Chan, the continuing owner, may have a valid concern in this area. He has to pay
his partner for his interest in these receivables; what if they are never collected? Chan must bear all the
risk. The buy-out agreement could be amended to specify that the book value of Baaz's equity be
adjusted for any uncollected receivables in excess of the allowance. Fortunately, the five-year lag
would easily accommodate this adjustment, as all receivables would be settled — or written off —
over this time.
2. Inventory
Is the inventory really obsolete? Assets with no objectively verifiable future cash flow have to be
written off to current income, and Chan has given up trying to sell this slow-moving inventory. On the
other hand, it is not perishable, and it is still in the warehouse. A future sale is therefore possible. It
would be wise to review the sales history for this product and do some independent investigating into
the existence of a sales market. Baaz should be consulted to see if he feels this product is worthless.
Again, the impression is that Chan is trying to decrease income and net assets to reduce the buy-out
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price. If the inventory is a major motivating factor, the buy-out agreement could be renegotiated to
allow for reduction of the price if the inventory doesn't move over the next five years.
The proper accounting policy — write off or not — depends on the result of further investigation and
discussion with Chan and Baaz.
On a cautionary note, it is not clear that Chan will suffer, even if some receivables and inventory are
worthless. First, some inventory would be worth more than the book value paid to Baaz. Chan may
have to accept assets with market values below book value (the "bad") in order to get assets with
market value above book value (the "good"). Second, a payout of book value does not allow for
goodwill that the partnership has established. Chan may therefore be getting a reasonably good deal.
(Keep in mind, though, that this outcome is hard to assess and income is down.)
3. Amortization policy
The accounting policy for amortization of computer equipment has resulted in 40% of the capital cost
of the asset being written off this year, although the asset has only been owned for a few months. The
current year had little benefit from the equipment.
Is it realistic to write off most of such an asset over less than three years? Does this company need
leading-edge technology or is it likely to be able to use this equipment for five to seven years?
Chan should estimate the likely useful life of the equipment and retain the policy of straight-line
amortization over the life of the asset. Since the firm has in the past recorded a full year of
amortization in the year of acquisition, this policy is marginally acceptable. Prorating by month would
be more appropriate in these circumstances. However, if the amount is not material now that straightline amortization is used, and if Baaz is aware of the situation, the policy is permissible.
Recommendation
The allowance for doubtful accounts should be based on specific identification, as in prior years. Inventory
obsolescence should be investigated further and discussed with both partners before a write down is taken.
Computer equipment should be amortized on a straight-line basis over its useful life. The policy relating to
amortization in the first year of ownership should be re-evaluated and agreed on by the partners.
The buy-out agreement between Chan and Baaz should be re-evaluated to adjust for uncollectible accounts
and obsolete inventory.
Note on ethics
As the accountant of the partnership, I have been hired by both partners and owe a duty to both.
A meeting or a conference call between Chan, Baaz, and myself should be planned to discuss operating
results, accounting policies, and the buy-out agreement.
If Chan is not in agreement with my analysis and recommendations, Baaz should be contacted directly to
make him aware that his interests are being affected. I may have to assist in the renegotiation of the buy-out
agreement or arrange for an outside arbitrator if the two parties are in conflict.
Marking key
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Note: In the marking key that follows, bulleted items are worth the point value shown in brackets. The
available points often add up to more than the maximum points indicated to allow for alternative valid
approaches to a given situation. Maximum marks per section, or for the case as a whole, cannot be exceeded.
Overview
Partner buy-out based on book value for accounting (1)
Chan has incentive and power to minimize assets and income (1)
Baaz served by "fair" evaluation; needs operation to thrive to get money (1)
Maximum 2
Issues
Accounting policies for
Estimation of allowance for bad debts
Write-off of obsolete inventory
Amortization policy for computer equipment (1 mark for list)
Maximum 1
Analysis
Doubtful accounts:
Allowance required under GAAP but approach is subject to professional judgment (1)
Describe prior practice (1)
Percentage chosen this year is double the historical rate (2)
Concerns about recession vague (1)
Ethical concern that Chan is overestimating (1)
Ethical concern that Chan would be stuck with bad accounts in the future (that is, Baaz is treated too
well in current deal) (1)
Other valid points (1 each, maximum 3)
Inventory:
Inventory must be written off if it cannot be sold (1)
This inventory may not be obsolete: not perishable, still in warehouse (2)
Need to review evidence to suggest presence of market, etc. (2)
Ask Baaz his opinion (1)
Ethical concerns: effect on Chan; effect on Baaz (1 or 2)
Other valid points (1 each, maximum 2)
Amortization policy:
Policy chosen is aggressive; decreases income (1)
Asset only owned for a few months this year; little benefit (1)
Effective amortization period very short; does it represent the period of use? (1)
Ethical concerns: effect on Chan; effect on Baaz (1 or 2)
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Discuss part-year amortization (1)
Other valid points (1 each, maximum 2)
Maximum 13
Recommendation
A sensible recommendation, consistent with analysis
0 for no recommendations or illogical recommendations
1 for a weak recommendation
2 for intelligent, logical recommendations
Maximum 2
Communication
Organization, quality of expression
0 for unacceptable communication skills
1 for weak communication skills
2 for acceptable communication skills
Maximum 2
Overall — maximum 20
Note: There is no right answer to a case; marks are awarded for valid analysis and consistent
recommendation. The marking key is provided for guidance. You are not expected to cover all the points.
An unsatisfactory response
Read and evaluate the following (unsatisfactory) student response.
Overview
Chan is in a position where he can manipulate the financial position of the partnership for his own benefit,
and has chosen accounting policies that understate income and assets. This is not appropriate.
To begin a case well, you should identify the major users of the financial statements and the earnings or
disclosure pattern the entity is likely to adopt. The student should identify the presence of the buy-out
agreement and explain how to serve Baaz's interests.
Marks granted for overview: 1
Issues
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The accounting issues are accounting for obsolete inventory, accounting for the allowance for doubtful
accounts, and amortization methods.
The issues were clear in the case…hard to miss! The student simply itemized the issues here, with no
explanation. This is appropriate.
Marks granted for issues: 1
Analysis
Allowance for doubtful accounts
Chan is again trying to rip off his partner by understating the value of the accounts receivable. The allowance
should be based on past experience.
Use of slang ("rip off" ) is never acceptable in a written assignment. Keep the language formal. Second,
remember to whom this report is going — do you think Chan will appreciate this remark? Policy choice is
about objectivity, and this student has obviously taken a side. More effort should be invested in an evenhanded analysis. Again, there is no analysis, just a recommendation. You have to communicate your thought
process, not just the "bottom line."
Obsolete inventory
Obviously inventory isn't an asset if it can't be sold, and Chan looks as though he is on solid ground.
However, if he later "tried harder" and sold this inventory, he'd have a lot to gain and Baaz would have been
cheated. Therefore, it's important to look at evidence that the inventory is really obsolete. Chan is likely
wrong here, and the inventory should not be written off.
Off to a good start…the student explains why the write down is needed, and also explains how the users
would be affected by the write down. The recommendation is hasty, though — what evidence would you look
for to suggest either writing off or leaving the asset intact?
It's quite acceptable to include recommendations at the end of the relevant analysis. They can also be put in
a separate section at the end.
Amortization policy
Chan is incorrect in changing amortization methods simply to further his own interests. The amortization
policy of past years should be applied this year.
Is this an analysis or just a conclusion? It's important to provide analysis before providing the
recommendation. Explain the effect of the decision on the financial statements — that income is down as a
result, and a major portion of the asset written off in the first year, and over the first three years. Then ask if
this is a good way to measure the value received. If Baaz is served by "fair" accounting policies, try to
explain what "fair" would be in these circumstances.
Why weren't the issues dealt with in the order that they were listed in the issues section?
Marks granted for analysis: 1 + 3 + 0 = 4
Marks granted for communication: 2 (The report's grammar is acceptable.)
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OVERALL MARK: 8
Module 1 self-test
Question 1
Computer question
Ng and Foran began a partnership by investing $136,000 and $204,000, respectively. During the first year of
operation, the partnership earned $90,000. Each partner withdrew $2,000 per month from the partnership.
Required
Part a
Establish the distribution of profits for the partners including the percentage of total partnership profit,
assuming each of the four separate scenarios below:
1. There is no established agreement for sharing income.
2. The partners agree to share income by allocating a salary of $40,000 to Ng, $20,000 to Foran, and the
residual is split 2:1.
3. The partners agree to share income by allocating a salary of $25,000 to Ng, $15,000 to Foran, interest
of 5% on opening partner balances, and the residual split in proportion to opening partner capital
balances.
4. The partners agree to share income by allocating a salary of $65,000 to Ng, $60,000 to Foran, interest
of 5% on opening partner balances, and the residual split in proportion to opening partner capital
balances.
Part b
Prepare a statement of partners’ capital for Year 1, assuming distribution of income as in part a, step 4.
Note: Before you start this question, you should work through the computer activity in Topic 1.5. For an
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example of a statement of partner’s capital, as required in part (b), see page 4 of Hilton’s "Accounting for
Partnerships."
Procedure
1. Start Excel and open the file FA3M1Q1. This file can be found in the DATA subfolder where you
installed the course. (Before you begin working on the data files in this course, you must first
download them and save them to your hard drive. Click the data files link in the navigation pane, then
follow the instructions for downloading and saving the files.)
2. Click the sheet tab for M1Q1A1 (or M1Q1A2, M1Q1A3, M1Q1A4 as required).
3. Observe that rows 8 to 24 contain the data table. The schedule of partnership profit distribution starts
in row 26. This schedule is blank except for column and row labels.
4. Enter the appropriate formulas in rows 33 to 35.
5. Enter the necessary formulas in row 37, using a cross-adding IF statement as a further test of accuracy
in cell G37. (The sum of cells B37 to D37 should equal the sum of cells G33 to G35. If they don’t,
Excel should display an error function as a result of the IF statement.)
6. Enter the required formulas in row 39 to calculate the percentage of total partnership profit distributed
to each partner.
7. Save a copy of your completed worksheet.
8. Repeat steps 2 to 7 for each of scenarios 2 to 4.
Solution
Question 2
Computer question
Problem 10, page 31 of "Accounting for Partnerships"
Note: Ignore the requirement in the problem and answer the requirement listed below.
Required
Using the data in parts a and b of Problem 10, prepare a partnership liquidation schedule that shows the
February and March activities. Assume that cash is distributed only at the end of March.
Procedure
1. Start Excel and open file FA3M1Q2.
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2. Observe that rows 7 to 32 contain the data table. The schedule of liquidation starts in row 36. This
schedule is blank except for column and row labels.
3. Enter the profit and loss ratios in row 43, using cell references to the data table. Enter the appropriate
cell references in row 45 to set up the pre-liquidation balances.
4. Rows 46 and 50 require formulas to pick up the asset liquidation transactions from the data table.
Enter these formulas.
5. Rows 48 and 54 should contain subtotals of the previous transactions. These rows will contain the
updated balances in the accounts when the appropriate formulas have been entered.
6. Enter formulas in rows 47, 51, 52, and 53 to reflect payments made to creditors (whether the liability
was previously recorded or not). Liabilities/payments not previously recorded will affect the capital
accounts.
7. Complete the formula in row 55 to distribute the final cash to the partners.
8. Row 57 will contain the post-liquidation balances if you have entered the correct formulas.
9. When all the formulas have been entered correctly, save the file.
Solution
Question 3
Multiple choice
a. If the proprietary view of an organization is followed, which of the following statements is true?
1. The accounting equation is viewed as Assets = total equities (liabilities + equity).
2. The income statement has a focus on operating income before distributions to a variety of
stakeholders.
3. All groups except owners are viewed as outsiders, and all charges to outsiders are on the income
statement.
4. The entity is considered to have a separate existence apart from all groups of stakeholders.
b. Which of the following statements is true with respect to the mutual agency relationship of a regular
(that is, not a limited) partnership?
1.
2.
3.
4.
Mutual agency exists unless the partnership agreement states otherwise.
Partners can commit each other in contracts to third parties.
Contracts with third parties must be ratified by partners before they are legally enforceable.
Partners have unlimited personal liability.
c. Why would a partnership with annual net income of $10,000 consider incorporation?
1.
2.
3.
4.
Reduce income tax on annual income
Allow business losses to be deducted from other income of the partners
Reduce requirements of government regulation and annual reporting
Limit personal liability
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d. Which of the following is not a reporting requirement for unincorporated businesses, as set out in the
CICA Handbook?
1. A balance sheet, income statement, and cash flow statement
2. An indication that the entity is unincorporated and that the statements do not include all the
assets, liabilities, revenues, and expenses of the owners
3. A net worth statement
4. A statement showing the changes in owners’ equity, by source, for the period
e. An entity chooses to record the value of stock options granted to employees as an expense on the
income statement, instead of the more common disclosure alternative. This policy lowers net income
and retained earnings, but results in higher common share values. The expense is not tax-deductible,
according to the provisions of the Income Tax Act. What would be the most likely motivation of this
company?
1. It has a covenant on net income (net income must be at least a certain level) in a lending
arrangement or interest charged will increase; the entity is concerned that net income remain
healthy.
2. It is motivated by political pressures.
3. It has a covenant on the current ratio (current assets divided by current liabilities) in a lending
arrangement and is concerned that the current ratio remain healthy.
4. It is trying to minimize income tax.
f. Which of the following relates to "differential accounting"?
1. Partnerships do not expense salaries and interest on partner capital balances.
2. Simpler accounting policies can be chosen in certain specific areas with no deviation from
GAAP.
3. Partnerships are not allowed to use the equity method to account for significant influence
investments.
4. Partner’s withdrawals are accounted for in a manner similar to dividends, when comparing a
partnership to a corporation.
Solution
Question 4
Problem 7, pages 28-29 of "Accounting for Partnerships"
Note: There should be two alternatives presented for proposal A and one alternative method for proposal B.
The approach to proposal B should be based on the norm in practice (see Topic 1.6). Allocations are based
on Burnham’s share of capital (20%), not profits (25%).
Solution
Question 5
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Financial Accounting 3 [FA3]
Shiraf, Fraser, and Simone are partners; their capital balances and profit and loss ratios are as follows:
Shiraf
Fraser
Simone
$256,000
344,000
126,000
.6
.2
.2
Fraser retires and receives a cash payment.
Required
Provide two alternative journal entries (for each case — a total of four entries) to record Fraser’s retirement
assuming that:
Case 1. Fraser is paid $400,000
Case 2. Fraser is paid $295,000
Solution
Question 6
Case analysis
Tan and Therson (Tan) is a partnership of lawyers. It was recently formed through a merger of two
predecessor partnerships: Tan and Harris (TH) and Therson and Smith (TS). The merged firm has 38
partners, six from TH and 32 from TS, and a total of 75 employees. On the date of the merger, Tan
purchased land and an office building for $1.25 million, and fully computerized their new office. The
partners have decided that the financial statements of Tan will be audited annually, although neither of the
predecessor firms was audited.
Tan has arranged a line of credit with a bank that allows the partnership to borrow up to 75% of the carrying
value of receivables and 40% of the carrying value of work in progress recorded in the monthly (unaudited)
financial statements. This same bank provided loan financing of $750,000 for the land and building. The
bank requires audited annual financial statements.
The partners have been actively engaged in establishing and managing the practice and have paid little
attention to accounting policies.
The partnership agreement requires an annual valuation of the assets and liabilities of the firm at current
replacement cost. This valuation is to be used to determine the payment made by the firm to a withdrawing
partner and the contribution to be made to the partnership by a newly admitted partner. The partners are
unsure of the accounting implications of this requirement. Current replacement costs could be recorded in the
books each year, or just acknowledged in a separate report.
Before the merger, TH recorded revenue when it received payment from the client. Time reports were used
to keep track of the number of hours worked for each client, although this information was not recorded in
the accounting system. When a bill was sent, the account receivable would be recognized, but revenue was
deferred until collection. In general, accounting records were not well maintained.
In contrast, work in progress was recorded for employees of TS at their regular billing rate, on a client-byclient basis, based on the hours worked, even though the full amount was not always recoverable. When
clients were billed, work in progress was reduced and accounts receivable was increased. When bills were
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Financial Accounting 3 [FA3]
issued, and at year end, an adjustment was made to write off any amount in work in progress that was
uncollectible. Thus, revenue was recognized as work was done, subject to the valuation adjustment.
In both firms, collection of client accounts was slow. That is, a client might not pay a bill for up to a year
after it was presented. The partners have made serious efforts to improve collection experience since forming
Tan, but the average age of accounts receivable is still six to eight months.
Each partner receives a maximum monthly withdrawal payment, which represents an advance on the
partner’s share of profits. Profits are split on the following formula:
1. First, interest of 5% on the opening capital balances
2. Remaining profit, after "interest", is allocated on the relative number of billable hours logged by each
partner. Both the total billable hours and each partner’s billable hours are reduced for time spent that
cannot be recovered from clients. That is, assume that Partner 14 recorded 3,000 billable hours during
a year, of which 450 were considered unbillable. Partner 14 would be acknowledged as having 2,550
hours in the formula.
Partners are permitted to withdraw, in cash, up to 80% of income allocated to them within 30 days of the
year end. For example, if Partner 14 was allocated $78,000 of income, and had withdrawn $50,000 during
the year, the partner would be allowed $62,400 ($78,000 × .8 = $62,400) for the year and an additional yearend withdrawal of $12,400 ($62,400 – $50,000). This equity may be left invested in the partnership, but
most, if not all, partners are expected to take the maximum withdrawals. The remaining 20% of profits must
be left in the partnership.
Your firm has been engaged by Tan to prepare a report advising the partnership on financial accounting
issues. You realize that asset valuation (historical cost versus current replacement cost) and revenue
recognition are critical choices of accounting policy.
Required
Prepare the report.
Source: Based on Case 4-3, Smith and Stewart, in Beechy, T.H., and Conrod, J.E.D. Intermediate Financial
Accounting, Volume 1, Second edition, (Toronto: McGraw Hill, 2002), pages 168-169. Used with
permission.
Note: Case analysis is limited to 1,000 words.
Solution
Self-test - Content Links
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Financial Accounting 3 [FA3]
Self-test 1
Question 1: Computer solution
Part a
Step 1
Step 2
Step 3
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Step 4
Computer formulas
Note: the formula in cell G35 could be = SUM (B35: D35).
Part b
Ng and Foran Partnership
Statement of Partner’s Capital
For the year ended Dec 31, Year 1
Opening investment
Ng
Foran
Total
$136,000
$204,000
$340,000
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Financial Accounting 3 [FA3]
Add net income
Deduct drawings
Balance, end of year
51,000
187,000
24,000
$163,000
39,000
243,000
24,000
$219,000
90,000
430,000
48,000
$382,000
Self-test 1
Question 2: Computer solution
Self-test 1
Question 3 solution
a. 3)
In the proprietary view, charges to outsiders — interest, tax, wages — are expenses, so item 3 is
correct. All other items describe the entity view.
b. 2)
Mutual agency allows one partner to contract on behalf of all partners; item 2 is correct. Mutual
agency cannot be eliminated in the partnership agreement, so item 1 is incorrect; contracts do not have
to be ratified, so item 3 is incorrect; and personal liability is not a feature of mutual agency, so item 4
is incorrect.
c. 4)
The corporate form will limit personal liability. Item 1 is incorrect because at low levels of income, a
corporation will have higher income tax rates. Business losses can be deducted from other employment
income only if the entity is a partnership, so item 2 is incorrect, and corporations have higher
regulation and reporting requirements, so item 3 is incorrect.
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Financial Accounting 3 [FA3]
d. 3)
A net worth statement is not part of the reporting requirements of an unincorporated entity; all other
items are required.
e. 2)
Expensing stock options will reduce net income, and reduce the apparent profitability of the
corporation; this may help avoid political attention. Item 1 is incorrect because income is reduced by
the choice of policy, item 3 is incorrect because the policy will not change the current ratio, and item 4
is incorrect because the question states that the expense is not tax deductible.
f. 2)
Item 2 is the definition of differential accounting; item 1 and item 4 are correct statements but not
related to differential accounting. Item 3 is incorrect because the equity method may be used if the
partnership wishes.
Self-test 1
Question 4 solution
Proposal A:
Alternative 1:
Cash
Asset
Burnham, capital [20% of ($200,000 + $70,000)]
Smith, capital (50% of $16,000)
Jones, capital (30% of $16,000)
Fleesum, capital (20% of $16,000)
Alternative 2:
Asset (or Goodwill)
Smith, capital (50% of $80,000)
Jones, capital (30% of $80,000)
Fleesum, capital (20% of $80,000)
$70,000 ÷ 0.2 = $350,000; actual assets are ($200,000 + $70,000)
$350,000 – $270,000 = $80,000
Cash
Asset
Burnham, capital
Proposal B:
Transfer 20% from each partner’s account; no new assets in the partnership.
Smith, capital (20% of $85,000)
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45,000
25,000
54,000
8,000
4,800
3,200
80,000
40,000
24,000
16,000
45,000
25,000
70,000
17,000
Financial Accounting 3 [FA3]
Jones, capital (20% of $65,000)
Fleesum, capital (20% of $50,000)
Burnham, capital
13,000
10,000
40,000
Self-test 1
Question 5 solution
Case 1:
Fraser is paid $400,000:
Alternative 1:
Fraser, capital
344,000
Shiraf, capital [(0.6 ÷ 0.80) × $56,000]
42,000
Simone, capital [(0.2 ÷ 0.80) × $56,000]
14,000
Cash
400,000
Alternative 2:
Goodwill
280,000
Shiraf, capital (0.6)
168,000
Fraser, capital (0.2)
56,000
Simone, capital (0.2)
56,000
Fraser’s account must be credited for $56,000
($400,000 – $344,000)
This represents 20% of goodwill of $280,000
($56,000 ÷ 0.2)
Fraser, capital
400,000
Cash
400,000
Case 2:
Fraser is paid $295,000:
Alternative 1:
Fraser, capital
344,000
Shiraf, capital [(0.6 ÷ 0.80) × $49,000]
36,750
Simone, capital [(0.2 ÷ 0.80) × $49,000]
12,250
Cash
295,000
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Alternative 2:
Shiraf, capital (0.6)
147,000
Fraser, capital (0.2)
49,000
Simone, capital (0.2)
49,000
Assets
245,000
Fraser’s account must be debited for $49,000
($295,000 – $344,000)
This represents 20% of asset impairment
of $245,000 ($49,000 ÷ 0.2)
Fraser, capital
295,000
Cash
295,000
Self-test 1
Question 6: Case analysis solution
To: Partners, Tan and Therson
Overview
The major users of the financial statements and their needs are
The bank. The bank will use the financial statements in assessing Tan’s future cash flows to determine
whether these amounts are likely to be sufficient to repay interest and principal amounts to the bank. In
addition, the bank will look to the balance sheet to confirm that any loans advanced to Tan are within
the agreed limits, namely, 75% of the carrying value of receivables and 40% of the carrying value of
work in progress.
Partners. Partners will use the financial statements primarily to assess the firm’s performance.
The partnership also needs financial statements to serve as the "annual valuation." In addition, the
partnership will want the financial statements to be prepared in such a way that will maximize loans
from the bank. Finally, partners will use the statements to determine the income amounts to be
included in their individual tax returns.
There is an ethical responsibility to make sure that the financial statements are appropriate for their
intended uses: to faithfully represent security for debt without overstatement (unfair to the bank) or
understatement (unfair to the partners). Tax minimization is perfectly ethical within the framework of
rules provided by the Income Tax Act: this is tax planning, not tax avoidance. Finally, the partners will
want to deal ethically with one another as they retire or withdraw, as they will all be there at some
time.
Issues
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Financial Accounting 3 [FA3]
1. Asset valuation
2. Revenue recognition
Analysis and recommendations
1. Asset valuation
The partnership agreement requires an annual valuation of the firm’s assets and liabilities. The annual
valuation is to be used in determining payments to be made by the firm to retiring or withdrawing
partners and contributions to be made to the firm by new partners. It is not clear what form the
partnership intends the annual valuation to take. Financial statements could be prepared using current
replacement costs (instead of historic cost). Or, financial statements using historic-cost values plus a
separate, annual valuation report could be prepared.
Although the use of current values is generally not in accordance with generally accepted accounting
principles (GAAP), Tan’s financial statements do not have to conform to GAAP. What matters is
whether the historic cost values prescribed by GAAP or some other basis of valuation will be the most
useful to the users of Tan’s financial statements. However, if current costs are used, the financial
statements will not be in accordance with GAAP. This may disturb the banker, who is providing
significant financial support for the partnership. The partners will obtain all the information they need
with a supplementary report.
We recommend valuing net assets at historic cost in the primary financial statements, accompanied by
a special report on current value to be used for valuation purposes.
(Alternatively, current cost information could be suggested and supported, noting that this would
trigger a qualified audit report.)
2. Revenue recognition
Tan has three options for timing the recognition of revenue:
1. Record revenue as work proceeds.
Under this option, all WIP will be recorded at regular billing rates. The asset balance will
increase as early as possible, thereby maximizing the limits established on the bank loan as early
as possible. However, the actual amount billed to the client may be more or less than the total
hours spent on the client’s work. If the discrepancies are material, the usefulness and credibility
of the financial statements will be very limited, since revenues for prior periods will constantly
have to be adjusted to reflect actual revenues. To the extent that the likely realizable value can
be accurately estimated, based on past experience perhaps, then these adjustments may not be
material. However, there may be no accurate way to predict unbillable time prior to actually
preparing the bill on completion of the job. A lack of accuracy in the monthly statements will
harm the partnership, as the bankers rely on these statements and will be concerned if the
statements do not provide reliable measures for loan limits. This alternative represents the prior
practice of TH and TH partners will be familiar with these practices.
If revenue is recognized early, it would be allocated to partners at year end, and 80% would be
available for withdrawals. Thus, early revenue recognition, perhaps before collection, would put
strains on the cash flow of the partnership. Collection experience is improving, but is still 6 to 8
months.
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2. Record revenue when the amount has been collected.
Under this option, revenue will be recognized when the actual collectible amount has been
received. Therefore, there will be no subsequent adjustments to the income statement, as may
occur under option 1. Accounts receivable will be recorded when amounts are billed, and still
serve as collateral, and WIP would be recorded at cost. Revenue would be recorded only when
cash is eventually received. However, this option unduly delays the recognition of revenue. It is
very conservative, unless there are doubts about the collectability of accounts. While collection
is slow, there were no concerns raised about ultimate collection.
This alternative will cause no cash flow problems for the partnership, but it will be onerous for
the partners, who will receive their share of profits later. On the other hand, it provides a great
incentive to speed collection. This method also provides a highly conservative (that is, low) WIP
balance for loan collateral, reducing the funds available to the partnership. This is the most
cautious alternative.
3. Record revenue when the amount is billed to the customer.
Under this option, revenue is recognized when the job is complete. This is more typical revenue
recognition — analogous to delivery of goods. At this point, there is certainty about the billable
amount compared to the time invested. Reliability of the financial statements is enhanced over
option 1. Accounts receivable will be recorded when amounts are billed, and still serve as
collateral, and WIP would be recorded at cost. The partnership still runs the risk of recognizing
revenue before collection in that some profit will have to be distributed to the partners before
collection. Bank financing may be adequate to provide for this cash flow. Cash budgets should
be prepared to analyze the adequacy of cash resources.
While the partners may well prefer early revenue recognition in alternative 1, it may not be
possible to estimate eventual billings. Estimation errors in the financial statements would reduce
their credibility, and monthly statements must be credible for the banker. Early revenue
recognition would put cash flow pressures on the partnership, because of the arrangement for
profit distribution. Alternative 3 is recommended as typical for revenue patterns; it recognizes
revenue when earned. If it is not possible because of poor cash flow projections, then alternative
2 must be considered, although it involves very delayed revenue recognition. Obviously, faster
collection is a concern for the partners.
Module 1 summary
Partnership equity accounting
This module reviews the basic legal structure of a partnership and covers various accounting issues, such as
partnership formation, dissolution, profit distributions, and admission or retirement of a partner. Computer
activities cover the distribution of partnership income and liquidation using a spreadsheet program. The
module concludes with a discussion of ethical accounting policy choice and an introduction to case analysis.
Accounting policy choice can be motivated by management incentive plans, the presence of lending
covenants, political motivations, or taxation. Compliance with GAAP involves many choices and judgments
that may be slanted, appropriately or inappropriately. The accountant has serious ethical responsibilities in
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Financial Accounting 3 [FA3]
this environment.
You will find a summary of key points on pages 22-23 of "Accounting for Partnerships."
Describe the conceptual nature of ownership interests.
Ownership interests can be classified according to two viewpoints:
1. The proprietary view:
Firm and owners are one and the same
Creditors are outsiders
Narrow view of the firm
2. The entity view:
Firm is separate entity
Multiple stakeholders:
shareholders
creditors
government
society
Broad view of the firm
Explain the rights and obligations of a partner and the concept of mutual agency.
The rights and obligations of a partner are determined by the relevant provincial Partnership Act, but
can be altered by a partnership agreement.
The basic rights of a partner are
to share equally in the capital and profits of the business
to be reimbursed for business expenses
to receive interest on excess contributions ("advances")
to contribute to the management of the partnership
to consent to the admission of new partners
These rights can be specifically changed by a partnership agreement.
Partners' obligations arise from the mutual agency relationship that partners have to each partner and
to the firm.
Agency is a legal relationship wherein one person (the agent) represents another (the principal) and
can enter into contracts on behalf of the principal with third parties.
Partners' obligations include
Joint liability for the debts and obligations of the firm; partnership creditors can look to the
personal assets of any of the partners to satisfy their claims.
Liability for the negligence, torts, and breaches of trust of their partners.
Explain how a partnership is created and dissolved.
Partnerships are created voluntarily by the actions of two or more individuals (or corporations). The
business typically begins with an initial investment.
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Partnerships can be dissolved voluntarily or through legal requirement caused by the death, mental
incapacity, bankruptcy, or insolvency of a partner.
Compare and contrast the elements of a general partnership and a limited partnership.
A limited partnership has one or more general partners, with unlimited personal liability, and one or
more limited partners, whose liabilities are limited to their investment. These limited partnerships are
often used to structure tax advantages for the limited partners.
Account for the creation of a partnership and its ongoing operations, including the
distribution of net income (loss) among the partners.
When a partnership is created, capital accounts are set up to record contributions, drawing accounts are
set up to record periodic withdrawals, and, if necessary, loan accounts are used to record repayable
advances. Net income (loss) from ongoing operations is credited (debited) to the partners' capital
accounts.
Profit allocations may be based on
specified ratios
"interest" plus "salary"; residual allocated by a specified ratio
Account for admission, retirement, and withdrawal or death of a partner.
A new partner can be admitted two ways:
1. Admission through purchase of interest of existing (old) partner
Method A: transfer book value
Method B: recognize goodwill, then transfer book value
2. Admission through payment to the partnership
Bonus method: Old partner's equity accounts are increased or decreased
Asset revaluation method: Price paid used to adjust assets
Retirement or withdrawal of a partner can be at, above, or below book value, and can be based on:
goodwill recognition (not recommended)
bonus
Partnerships automatically dissolve on the death of a partner. The partnership agreement can provide
for continuity.
Account for the liquidation of a partnership.
A liquidation schedule shows
the realization of assets and the corresponding allocation of gains or losses to the partners
payment of creditors before making any distributions to the partners
settlement of partners' loans and then capital deficiencies
lastly, settlement of partners' balances
Prepare the financial statement for a partnership.
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The major structural differences between corporate and partnership financial statements are income
taxes and the disposition of the "salary" paid to the owner/partner.
No provision should be made for income taxes as these are the personal liabilities of the partners.
Salaries to the partners, if presented, should be disclosed separately; otherwise, the fact that no salaries
have been charged should be disclosed in the notes.
The statement of partners' equity should set out the details of each partner's capital contributions,
drawings, and net income or loss for the period.
Disclosure of the nature of the partnership organization is an integral part of partnership financial
statements.
Explain the importance of information and policy choice in contracting situations and
describe some typical indications for accounting policy choice.
Accounting policy choice is important when financial statement data are used in contracts. While this
issue is important for corporations, the use of the partnership financial statements in distribution of net
income (loss), in buy-outs, and in establishing capital entitlements makes policy choice for
partnerships particularly critical.
Accounting policies must be perceived to be fair to all contracting parties.
When making accounting policy choices, an accountant considers
GAAP
fair presentation
the firm's specific circumstances
the needs of the financial statement users
Accounting policy choice may be influenced by such factors as management incentive plans, lending
covenants, political motivations, taxation, and contracts.
Perform a simple case analysis.
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