CHAPTER 2 PARTNERSHIPS: ORGANIZATION AND OPERATION

HIGHLIGHTS OF THE CHAPTER

1. The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on, as co-owners, a business for profit. Although a partnership may be formed without a written contract, a carefully prepared written contract is desirable. Today, the limited liability partnership (LLP) has supplanted the general partnership as the primary form of partnership organization. The basic characteristics of the limited liability partnership form of business organization are: a. Ease of formation A limited liability partnership may be created by written agreement or may be implied by the conduct of two or more persons. b. Limited life A partnership may be ended by the death, retirement, bankruptcy, or incapacity of any partner. c. Mutual agency Each partner has the authority to act for the partnership. d. Co-ownership of partnership assets and earnings Partners have an equity in the net assets and earnings of the partnership; individual partners do not own specific assets of the partnership. The income tax status of a business enterprise and its owners should be considered before choosing between the corporate and the partnership forms of organization. Unlike a corporation, a partnership is not a taxable entity. A partnership is required to file an information return showing the computation of net income and the allocation of the net income among the partners. A Subchapter S corporation may elect to be treated as a partnership for income tax purposes. For financial accounting, a limited liability partnership is considered to be a separate entity, despite the fact that a partnership legally is an association of individuals. A limited liability partnership also is a separate legal entity because it may own property, be sued, or bring suit against others. In the fields of law, medicine, and public accounting, the limited liability partnership currently is the usual form of organization. Among the points to be covered by a partnership contract are the following: a. The date of formation and the planned duration of the partnership, the names of the partners, and the name and business activities of the partnership b. The assets to be invested by each partner, the procedures for valuing noncash investments, and the penalties for a partners failure to invest and maintain the agreed amount of capital c. The authority of each partner and the rights and duties of each d. The accounting period to be used, the nature of accounting records, financial statements, and audits by independent public accountants e. The plan for sharing net income or losses f. The drawings allowed to partners and the penalties, if any, for excessive withdrawals g. Insurance on the lives of partners, with the partnership or surviving partners named as beneficiaries

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h. Provision for arbitration of disputes and liquidation of the partnership

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Three types of ledger accounts generally are maintained for each partner: (a) capital accounts, (b) drawing or personal accounts, and (c) accounts for loans to or from partners. Subsequent to the original investment, partners equities are increased by net income; partners equities are decreased by withdrawals and by a share of net losses incurred by the partnership.
Periodic drawings are recognized by debits to the partners drawing accounts. At the end of an accounting period the net income or loss is transferred to the partners capital ledger accounts in the income-sharing ratio, and the debit balances in the drawing accounts are closed to the partners respective capital accounts. When a partnership receives a loan from a partner, the Loans Payable to Partners ledger account is credited; when a partnership makes a loan to a partner, the Loans Receivable from Partners account is debited. Noncash assets invested in a partnership should be appraised and recognized at their current fair values at the time the assets are invested. Any gain or loss on the disposal of noncash assets invested by the partners is divided among the partners in the incomesharing ratio. Partners may agree on any type of income-sharing plan; however, if partners do not formulate an explicit plan for sharing net income or losses, the Uniform Partnership Act requires that net income or losses be shared equally among the partners. Some possible plans for sharing net income or losses are: a. Equally, or in some other ratio b. In the ratio of the partners capital account balances on a particular date, or in the ratio of average capital account balances during the year c. Allowing interest on partners capital account balances and dividing the remaining net income or loss in a specified ratio d. Allowing salaries to partners and dividing the resultant net income or loss in a specified ratio e. Bonus to managing partner based on income f. Allowing salaries and interest on capital account balances, and dividing the remaining net income or loss in a specified ratio When average capital account balances are used as a basis for income sharing, or as the basis for interest computations, debits to the partners drawing accounts generally are not considered in the computation of the average capital account balances, because these changes are considered to be withdrawals of current earnings. The partnership contract should specify the items to be included in the computation of the average capital account balances. Computation of the average capital account balance for partner Clark is illustrated as follows: Clark, Capital

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Apr. 1

12,000

Jan 1 bal. Aug. 31

Fraction of year unchanged

60,000 15,000

Capital account balance $60,000

48,000

1/4 5/12

$15,000

20,000

63,000

1/3

21,000
$56,000

Average capital account balance

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If a partnership contract includes interest on capital and/or salaries in the division of net income or loss, interest and salaries are provided in full even if the partnership incurs a net loss (before allowances for interest and salaries). A partnership contract that permits partners to make regular drawings should specify whether such drawings are intended to be a factor in the division of net income or loss. A partner acting as manager of a partnership may be allowed a bonus, based on either income before or income after the bonus. If income before the bonus is $22,000, a bonus of 10% of income after the bonus would be $2,000 ($22,000 x 1/11 = $2,000). After each partners share (including bonus, interest, salary, and any balance) of net income is computed, the credit balance of the Income Summary ledger account is closed to the partners capital accounts. Each partners share of net income or loss may be displayed in the income statement or in a separate exhibit accompanying the income statement. If salaries allowed to partners are included in operating expenses, the amount of such salaries should be disclosed. A statement of partners capital is a financial statement prepared for a partnership at the end of the accounting period. It shows for each partner the beginning capital, additional investments or withdrawals of a permanent nature, share of net income or loss for the period, regular drawings, and the ending capital. In addition, a Combined column is used to show totals of all items included in the statement. Errors in the measurements of partnership net income or loss for prior accounting periods should be analyzed carefully when the income-sharing ratio is changed or when changes in membership of a partnership take place. Each partners capital should be restated based on that partners share of the adjustment to net income or loss for each prior period. The operation of a limited liability partnership generally is not interrupted by a change in the membership of the partnership. Legally, a change in membership terminates the existing partnership and creates a new partnership. Changes in membership result when a partner is admitted to the firm, retires, or dies. Before admission of a new partner is recorded, the partnership accounting records should be brought up to date. Current fair values of assets should be considered in setting the amount to be invested by the incoming partner for a share of the net assets of the partnership. The admission of a new partner may take place in one of two ways: (a) through the acquisition of all or part of the interest of one or more of the existing partners or (b) through the investment of assets in the partnership by the new partner. If the new partner acquires an ownership interest from one or more of the existing partners, the transaction is recorded by a debit to the capital account of each selling partner and a credit to the capital account of the new partner. For example, if Young has a capital account balance of $10,000 representing a 20% equity in a partnership, and Young sells the entire equity directly to Zeno for $15,000, the transaction is recorded in the partnership accounting records as follows:

Young, Capital Zeno, Capital

10,00 0 10,00 0

To record transfer to Youngs interest in partnership to Zeno.

The amount paid by Young to Zeno is not entered in the partnership accounting records because no assets are received by the partnership. When a new partner makes an investment in a limited liability partnership, the following three situations may be encountered: a. The new partners capital account is credited for the current fair value of the assets he or she is investing, and the capital accounts of the existing partners remain unchanged. b. The new partner may invest an amount that is larger than his or her percentage share of the net assets, thus potentially requiring the recognition of a bonus or goodwill to the existing partners. c. The new partner may invest an amount that is less than his or her percentage share of net assets, thus potentially requiring the recognition of a bonus or goodwill to the new partner. When the net assets (assets less liabilities) of the limited liability partnership are fairly stated in the accounting records, the bonus and goodwill methods of recording the admission of a new partner are illustrated by the examples below: Assume that Ames and Borg, partners of Ames & Borg LLP, have capital account balances of $80,000 and $100,000, respectively, and that they share net income or losses equally. Chun is to be admitted as a new partner for an investment of the net assets specified in (1) and (2) below of a single proprietorship for a 25% interest in the net assets of the partnership. Chun is to have a 30% interest in net income or losses, and Ames and Borg each will have a 35% interest. Net Assets Invested by New Partner in a Limited Liability Partnership

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Type of solution Bonus

Goodwil l

(1) $50,000 (bonus or goodwill to new partner) Net Assets 50,00 0 Ames, Capital 3,750 Borg, Capital 3,750 Chun, Capital 57,50 0 New total capital: $180,000 + $50,000 = $230,000. Bonus to Chun: ($230,000 x 0.25) $50,000 = $7,500, divided equally between Ames and Borg. Net Assets 50,00 0 Goodwill 10,00 0

(2) $70,000 (bonus or goodwill to existing partners) Net Assets 70,00 0 Ames, Capital 3,750 Borg, Capital 3,750 Chun, Capital 62,500 New total capital: $180,000 + $70,000 = $250,000 Bonus to Ames and Borg: $70,000 ($250,0000 x 0.25) = $7,500, divided equally between Ames and Borg. Net Assets Goodwill 70,00 0 30,00 0

Chun, Capital Capitalize existing partners investment ($180,000 3/4 = $240,000). $240,000 x 1/4 = $60,000. Goodwill to Chun: $60,000 $50,000 = $10,000
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60,00 0

Ames Capital
Borg, Capital

15,000 15,000 70,000

Chun, Capital Capitalize Chuns investment ($70,000 1/4 = $280,000). Goodwill to Ames and Borg: $280,000 $250,000 = $30,000, divided equally between Ames and Borg.

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A new partner may invest an amount that involves the recognition of a bonus or goodwill to existing partners for the privilege of becoming a member of a limited liability partnership with high earning power. In contrast, existing partners may allow a bonus or goodwill to the new partner when he or she has unusual ability or invests the net assets of a business enterprise of superior earning power in the partnership. When a new partner invests an amount of cash larger than the carrying amount of the interest in net assets that he or she acquires, the transaction should be recorded by the bonus method. Recording the implied goodwill in such situations is not acceptable (in the opinion of the author) because the implied goodwill has not been acquired by the partnership. The restatement of partnership assets to current fair values before a new partner is admitted to a limited liability partnership may be the most convenient method of achieving equity among the partners. A retiring partner may receive an amount in settlement for his or her equity from the partnership or may sell his or her equity, either to an existing partner or to an outsider. A settlement price to be paid from partnership assets should be determined pursuant to the partnership contract. In most cases, the equity of the retiring partner is based on the current fair values for all partnership assets. The current fair values may or may not be entered in the accounting records of the partnership. If the amount paid to a retiring partner differs from the carrying amount of his or her equity, the difference should be recorded as a bonus to the retiring partner or a bonus to the continuing partners. Goodwill should not be recognized by the partnership when the amount paid to the retiring partner exceeds the carrying amount of the partners equity. The final settlement with a retiring partner often is deferred for some time after withdrawal to permit the measurement of net income or loss to date of withdrawal and the accumulation of sufficient cash to pay the retiring partner. Terms of settlement with the estate of a deceased partner generally are specified in the partnership contract. The journal entries to record payments to a deceased partners estate are similar to journal entries to record the settlement with a retiring partner. Legal provisions governing limited partnerships are provided by the Uniform Limited Partnership Act. Limited partnerships differ in several respects from limited liability partnerships, especially with respect to the rights and obligations of limited partners. The formation of a limited partnership is evidenced by a certificate filed with the county recorder, which includes a number of items in addition to those found in the typical partnership contract of a limited liability partnership.

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The membership units offered to prospective limited partners are subject to the Securities Act of 1933, which may require registration of the units with the Securities and Exchange Commission. The SEC has provided standards for financial statements of limited partnerships subject to the SECs jurisdiction. A significant requirement is the disclosure of per-unit information in the income statements and balance sheets of limited partnerships.