Chapter 08 Partnerships: formation, operation and reporting PowerPoint presentation by Anne Abraham University of Wollongong 2009 John Wiley & Sons Australia, Ltd PARTNERSHIP DEFINED Partnership Act: The relationship that subsists between persons carrying on a business in common, with a view to profit Necessary attributes Must be an agreement View to earning a profit Co-ownership of the business ADVANTAGES AND CHARACTERISTICS OF A PARTNERSHIP Advantages Pooling of capital resources and multiple skills of individual partners Low cost Formed at little or no cost Subject to little regulation Partners may be able to operate with more flexibility because not subject to control of a board of directors May be tax advantages 1
Characteristics of a partnership Mutual Agency Each partner acts as agent for the partnership Each partner has authority to act on behalf of the partnership Unlimited liability Each partner personally responsible for all the debts of the business No limit to liability Personal assets are exposed Unattractive to wealthy individuals Characteristics of a partnership continued Limited life Ended if member dies, withdraws or retires, or becomes incapacitated Ended on the admission of a new member Ended via bankruptcy Ended if formation purpose is over Transfer of partnership interest Capital interest is personal asset PARTNERSHIP AGREEMENT Agreement covers: Name, location and nature Name, investment and duties of each partner Sharing of profits and losses Administrative details Withdrawals (drawings) Dispute resolution Admission/withdrawal of partners Partnership liquidation 2
ACCOUNTING FOR A PARTNERSHIP Formation Drawings Distribution of profits Change in partnership members Liquidation Method 1: Capital accounts which include profits and losses Capital account credited with investments Drawings account debited with withdrawal of assets or personal expenses Drawings account closed to capital P&L summary closed to profit distribution and allocated to capital accounts 8 Method 2: Fixed capital accounts Capital account credited with investments and debited with withdrawals of capital Drawings account debited with withdrawal of assets or personal expenses Drawings account closed to retained profits P&L summary closed to profit distribution and allocated to retained profits accounts 9 3
ACCOUNTING FOR THE FORMATION OF A PARTNERSHIP First step is to agree on carrying amount and fair value of assets to be contributed and liabilities to be assumed by the partnership Fair value is the amount for which an asset could be exchanged between knowledgeable, willing partners in an arm s-length transaction 10 ACCOUNTING FOR THE FORMATION OF A PARTNERSHIP continued Formation entry Date Assets Liabilities Partner A capital (Assets and liabilities contributed by Partner A to the partnership) 11 ALLOCATION OF PARTNERSHIP PROFITS AND LOSSES Consider for each partner: services performed capital invested business risk assumed Common methods fixed ratio fixed ratio based on capital balances fixed ratio allowing for interest and salary 12 4
ALLOCATION OF PARTNERSHIP PROFITS AND LOSSES continued Allocation entry Method 1 June 30 P&L Summary Profit Distribution June 30 Profit Distribution Partner A, Capital Partner B, Capital (Distribution of profit to partners) 13 ALLOCATION OF PARTNERSHIP PROFITS AND LOSSES continued Allocation entry Method 2 June 30 P&L Summary Profit Distribution June 30 Profit Distribution Partner A, Retained Earnings Partner B, Retained Earnings (Distribution of profit to partners) 14 Fixed ratio Split based as stated e.g. 7:3, say profit of $60 000 June 30 Becker, Capital $42 000 Cook, Capital $18 000 (Distribution of profit to partners) 15 5
Ratio based on capital balances Profit $60 000 Capital investment Becker $150 000 Cook 100 000 $250 000 Profit allocation Becker (150 000/250 000) x 60 000 = $36 000 Cook (100 000/250 000) x 60 000 = 24 000 $60 000 16 Ratio based on capital balances continued Method 1 June 30 Becker, Capital $36 000 Cook, Capital $24 000 (Distribution of profit to partners) 17 Ratio based on capital balances continued Method 2 June 30 Becker, Retained Earnings $36 000 Cook, Retained Earnings $24 000 (Distribution of profit to partners) 18 6
Fixed ratio after allowing for interest and salaries Becker Cook Total Interest on capital $150 000 x 10% $15 000 $100 000 x 10% $10 000 $25 000 Salaries to partners 18 000 10 000 28 000 Total interest & salary credited 33 000 20 000 53 000 Residual to be divided equally 3 500 3 500 7 000 Equity increase $36 500 $23 500 $60 000 19 Ratio based on capital balances continued Method 1 June 30 Profit Distribution $25 000 Becker, Capital $15 000 Cook, Capital $10 000 (Distribution of interest on profit to partners) 20 Ratio based on capital balances continued Method 1 June 30 Profit Distribution $28 000 Becker, Capital $18 000 Cook, Capital $10 000 (Distribution of salaries to partners) June 30 Profit Distribution $ 7 000 Becker, Capital $ 3 500 Cook, Capital $ 3 500 (Distribution of residual profit to partners) 21 7
Ratio based on capital balances continued Method 2 June 30 Profit Distribution $25 000 Becker, Retained Earnings $15 000 Cook, Retained Earnings $10 000 (Distribution of interest on profit to partners) 22 Ratio based on capital balances continued Method 2 June 30 Profit Distribution $ 7 000 Becker, Retained Earnings $ 3 500 Cook, Retained Earnings $ 3 500 (Distribution of residual profit to partners) 23 DRAWINGS AND LOANS MADE BY PARTNERS Drawings Method 1 Mar 20 Partner A, Drawings Cash at Bank (Cash drawings by Partner A) June 30 Partner A, Capital Partner A, Drawings (Closing entry for Partner A s drawings) 24 8
DRAWINGS AND LOANS MADE BY PARTNERS continued Drawings Method 2 Mar 20 Partner A, Drawings Cash at Bank (Cash drawings by Partner A) June 30 Partner A, Capital Partner A, Retained Earnings (Closing entry for Partner A s drawings) 25 DRAWINGS AND LOANS MADE BY PARTNERS continued Interest on drawings Method 1 June 30 Partner A, Capital Profit Distribution (Charging interest on drawings) Interest on drawings Method 2 June 30 Partner A, Retained Earnings Profit Distribution (Charging interest on drawings) 26 Loans or advances by partners Date Cash at Bank Advance from Partner A (Advance from partner) Date Interest Expense Cash at Bank/Interest Payable (Charging interest on advance) 27 9
FINANCIAL STATEMENTS FOR A PARTNERSHIP Special-purpose vs general-purpose report If the partnership is not a reporting entity it will prepare special-purpose financial statements If the partnership is a reporting entity it will prepare general-purpose financial statements Each partner s equity reported separately on the balance sheet 28 FINANCIAL STATEMENTS FOR A PARTNERSHIP continued Salaries, interest on capital and interest on drawings are not expenses No income tax expense because partnership is not a legal entity and not subject to tax Profit or loss allocation disclosed Balance sheet Statement of partners equity 29 30 10