partnership_and_corporation - Chapter 5 ACCOUNTING FOR A...

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Unformatted text preview: Chapter 5: ACCOUNTING FOR A PARTNERSHIP BUSINESS Partnership is an association of two or more individuals to carry on as co-owner of a business for profit. A partnership form of business organization is not restricted to any particular type of business; it can be service rendering, manufacturing or merchandising form of business. The partnership form of business offers many advantages to the sole proprietor who needs more capital, managerial assistance, or technical help i.e. it is established to use the advantage of combined capital, and management talent and experience. Partnership is created by a voluntary agreement made among partners for the purpose of business. At the time of establishing the partnership, the partners should have a written agreement for the points that can be sources of dispute later on like; the amount to be invested, limitations on withdrawals of funds, division of net income and net loss and the admission and withdrawal of partners. In addition to this, partners should have a clear understanding about their duties, obligations, rights and responsibilities to avoid later misunderstanding. Characteristics of Partnership Business Partnerships are treated as separate entities for accounting purpose and they differ from other form of business in many ways. The following are some of the important characteristics of partnership business. Limited Life- A partnership has a limited life. It can be ended any time because of withdrawal, bankruptcy, incapacity, or death of a partner. Similarly, admission of a new partner dissolves the old partnership. In the case of dissolution (change in number of owner), a new partnership is formed. Unlimited Liability- each partner is personally and individually liable for all liabilities of partnership. Creditors claim is first attached to assets of partnership and then to personal resources of any partner regardless of partner’s equity in the company. Some time there may be a limited partnership where by liability of a partner is limited to partner’s equity. However, there must be at least one partner with unlimited liability, often called general partner. Co-ownership of Property- Partnership assets are co-owned by all partners. The property of a partnership is an asset of the partnership and is owned jointly by all partners. Upon dissolution of the partnership and distribution of its assets, the partners’ claims against the assets are measured by the amount of the balances in their capital accounts. Mutual Agency –Each partner is an agent of the partnership, with the power to enter into contracts for the partnership. Because of mutual agency, any partner can bind the partnership to a business agreement as long as he or she acts within the scope of the company’s normal operations. Participation in Income- Each partner has the right to share in the company’s income and the responsibility to share in its losses. The partnership agreement should state the method of distributing income and losses to each partner. If the partnership agreement fails to detail how losses and income should be distributed, then they are distributed equally. Partnership Agreement- A partnership is created by a contract expressing the voluntary agreement among partners. The written contract, known as the partnership agreement or articles of partnership, should contain provisions like: -Name and capital contribution of partners -Right and duties of partners -Bases for sharing net income or net loss -Provision for withdrawal of assets -Provision for withdrawal and admission of partner. etc A partnership is relatively easy and inexpensive to organize, requires only an agreement between two or more persons. It has also the advantage of being able to bring together more capital, more managerial 1 skills, and more experience than would a sole proprietorship. On the other hand, it has disadvantages like unlimited liability and limited life. Formation of a Partnership Each partner invests cash or other assets or a combination of the two in accordance with the partnership agreement. Non-cash assets are valued at their fair market value on date of transfer to partnership. Invested assets are debited to their proper account and the capital account of the partner who contributed the assets is credited. Example1: If Joe and Bob form a partnership and Joe invests a truck (market value=Br10,000) and Bob invests Br.5000, the following entry would be made to record their investment in the partnership. Cash…………………………………………..5,000 Truck………………………………………...10,000 Joe, Capital……………………………………………….10,000 Bob, Capital………………………………………………..5,000 Example2: Lidia had owned and operated a sole business for a number of years. Her business had prospered, but success had also brought some problems. For one thing, competition had increased & customers were demanding a larger assortment of merchandise. Lidia decided to solve her capital problem by seeking to form a partnership with another person. Furthermore, she knew that a good partner would also assume a substantial share of the growing managerial responsibility. Lidia learned that her relative, Abebe has money and interested in owning a business. Lidia and Abebe arranged a meeting to explore the possibility of pooling their resources. She prepared a balance sheet to show the assets, liabilities, and owner’s equity of her business, as shown below, as of the date set for a meeting with Abebe. After their discussion, Lidia and Abebe agreed to form a partnership. Lidia Boutique Balance Sheet January 31, 19 00 Assets Cash in Bank Br. 350 Accounts Receivable 10,800 Less Allow. For Bad Debts (300) 10,500 Merchandise Inventory 39,000 Total Assets 49,850 Liabilities & Owner’s equity Accounts payable Notes payable Total Liabilities Owner’s Equity Lidia, Capital Total liab. & Owner’s Equity Br. 20,000 3,000 23,000 26,850 49,850 2 Determining the Value of Net Assets: Note that, each partner’s initial investment should be recorded at fair market value of the assets on the date of their transfer to the partnership. Therefore, formation of a partnership firstly requires an agreement of the partners as to how to value the assets to be invested by each partner. Lidia wanted to contribute the assets of her business to the new partnership. The partnership would also assume the liabilities of her firm. Abebe on his part, agreed to invest cash. However, the determination of the market value of Lidia’s net assets raised certain questions that have to be resolved. Abebe pointed out that some of the accounts receivable might not be collectible. On the other hand, Lidia noted that the inventory worth more than the amount shown on the balance sheet. Finally, they have reached agreement that allowance for uncollectible has to be valued at Br. 800 instead of Br 300. This means the customers accounts to be transferred to the partnership should be valued at Br 10,000 instead of Br 10,500. They also agreed that the book value of the inventory has to be increased by Br 1000 to reflect their current prices. The merchandise inventory should thus be valued at Br. 40,000 instead of Br. 39,000 when the transfer takes place. To avoid any future misunderstanding about the terms of their arrangement, Lidia and Abebe have signed a written contract that states the obligations and rights, duties and responsibilities, manner of distributing profits and losses. The name of the new partnership business was agreed to be the Style Clothing. Adjustments on Proprietorship Books: - Since the assets of the Lidia Boutique are to be transferred to the new partnership at amounts different from those shown on the balance sheet, it is necessary to adjust the Lidia’s equity in the business as follows: Jan 31. Lidia, Capital……………………….500 Allowance for Bad Debts…………………….500 Jan 31. Merchandise Inventory……………….1000 Lidia Capital………………………………..1000 Notice that the balance of Lidia Kasa, capital account is now Br 27,350 (26,850 - 500 + 1000). This is to reflect the revalued assets of the firm & to update Lidia’s capital. Recording the Partners Investment in the Partnership The initial investment made by the partners in Style Clothing partnership is recorded as follows: Lidia’s investment consisted the equity of her former business. The partnership assumed the revalued assets and liabilities. Lidia’s Capital account was credited for the difference between the two amounts. Feb. 1. Cash ………………………………...Br.350 Accounts Receivable………………..10,800 Merchandise Inventory………… .40, 000 Allowance for Bad Debts ……………………. … 800 Notes Payable………………………………….20,000 Account Payable……………………………… 3,000 Lidia, capital...……………………………… .27,350 (To record inversement made by lidia in the partnership) Note that the initial investment made by each partner should be recorded at current market value of the invested assets. Abebe has also invested cash of Br 30,750 in the new partnership .The entry to record his investment would be: 3 Feb. 1. Cash ……………..30,750 Abebe capital………………….30, 750 The balance sheet of the new partnership after recording partner’s initial investment would be: Style Clothing Balance Sheet February 1, 1900 Assets Cash Accounts Receivable Less Allow for Bad Debts Merchandise Inventory Total Assets Liabilities & Owner’s Equity Liabilities 10,800 Account Payable Br 20,000 800 10,000 Notes Payable 3,000 40,000 total liability 23,000 Owner’s Equity Lidia, Capital 27,350 Abebe Capital 30,750 ____ TotalOwner’sEquity Br 58,100 Br81,100 Total Liab. & O/Equity Br 81,100 Br31,100 Division of Net Income or Net Loss The article of partnership has to say something as to how to share net income or loss among partners. If the agreement is silent as to the sharing of net income and net loss, it will be distributed to each partner equally. If each partner is to contribute equal capital and service, the net income or net loss may be shared equally. If one partner contributes a larger portion of capital than other partners do, provision for unequal capital has to be considered in the agreement of division of net income or net loss. On the other hand, if the service of one partner is more valuable than that of the other partner, provision for unequal service again has to be considered. In general, agreement should specify the base for the distribution of net income or net loss. Example: Assume that during first year of operation Style Closing has earned net income of Br10, 000. Let us also assume that Lidia and Abebe have reached the following independent agreement as to the sharing of net income or net loss. A. No agreement as to the sharing of net income or net loss. B. Agreed to share based on the ratio of their original capital balance. C. Interest at 12% on original capital balance and the remaining equally. D. Annual Salary of Br 5000 to Lidia, Br 3000 to Abebe and the remaining equally. Solution Assumption A We have said that there has to be agreement as to the sharing of net income or net loss .If the agreement has kept silent about the income or loss sharing, it will be distributed to each partner equally. As per assumption A, there is no agreement as to income and loss sharing ratio, hence we will distribute the net income of Br10, 000 to each equally. Net income…………………………………………..Br 10,000 Division of net income to Lidia Abebe Total Divide equally……………. 5, 000 5000 10,000 4 The closing entry will be: Income summary …………10,000 Lidia capital………………………..5000 Abebe capital………………............5000 (To close the income summary account to capital account) Assumption B Total initial capital ……………….30750+ 27350=58,100 Lidia’s ratio: 27,750/58,100 Abebe’s ratio: 30,750/58,100 Net income……………………………………………………………………...10,000 Division of net income to Lidia Abebe Total Lidia (10,000 x (27,350/58,100)…………….Br4, 707 4,707 Abebe (10,000 x (30,750/58,100)…………… ____ 5,293 5,293 Total……………………………………… Br.4707 Br 5293 Br10,000 The closing entry will be: Income summary………….10, 000 Lidia capital……………………..4,707 Abebe capital……………………5,293 Assumption C Net income……………………………………………………………….Br.10,000 Division of net income to Lidia Abebe Total Lidia (12%of 27,350)…………………….Br 3,282 Br 3,282 Abebe (12% of 30,750)……………… Br 3,690 3,690 Remaining (Br3,028) equally……………….1,514 1,514 3,028 Total …………………………………….... Br 4796 Br 5,206 Br 10,000 The closing entry will be: Income summary ……….10, 000 Lidia capital……………….4,796 Abebe’s capital………… 5,206 Assumption D Net income ……………………………………………………………..10,000 Division of net income Lidia Abebe Total Salary to each………………………….. 5,000 3,000 8,000 Remaining 2000 Br equally …………… 1,000 1,000 2,000 Total …………………………………….. 6,000 4,000 1,0000 The closing entry will be: Income summary…………..10,000 Lidia, capital………………………6,000 Abebe, capital……………………...4,000 5 Financial Statement for Partnership Dear colleagues, financial statements of partnership are similar with that of sole proprietorship. However, the number of owner is more in partnership and hence the number of capital and drawing accounts is as many as the number of partner in partnership. In other words, separate withdrawal and capital accounts are maintained for each partner. Because, each partner has its own separate drawing and capital accounts. Income statement is the same except division among partner. Again, just like capital sole proprietorship the partner’s equity of partnership is affected by: Additional investment Drawing made by partner Net income or net loss of the period. As an example let us prepare owners equity statement for Style Closing using assumption D and assume that Abebe invested additional cash of 5000 and Lidia withdrew 3000 cash during the year. Style closing Partner’s equity statement Dec 31, 1900 Lidia Abebe Capital balance, February 1 …………27,350 30,750 Add: additional investment………… 5000 Net income……………………..6,000 4,000 Less: Drawing…………………… (3000) Total………………………………. .30350 39,750 Total 58,100 5,000 10,000 (3000) 70,100 Partnership Dissolution Dissolution is not liquidation; rather it is the change in the number of partners. The change in the personnel of the ownership is due to: Admission of new partner Withdrawal of existing partner Death of a partner. Admission of New Partner: A new partner is admitted to the existing partnership with consent of all existing partners. The admission of a new partner dissolves the old partnership. A partner may be admitted in one of two ways: 1. Purchasing an interest from an existing partner. 2. Investing assets in to the partnership. Admission by Purchasing the Capital of the Existing Partner: When a new partner is admitted to the partnership by purchasing the capital of current partner, the purchasing price is directly paid to the selling partner. It is a personal transaction between one or more of the existing partner and the new partner. Any money exchanged here is personal property of the participant and not the property of the partnership. On the other hand, the selling price paid to acquire may be or may not be equal to purchased equity. At this time, the only entry needed is the one that transfers the capital of selling (old) partner to purchasing (new) partner by the acquired capital regardless of the amount paid by entering partner. The amount paid to the old partner is a personal matter and not entered into the partnership’s books. Example: Refer to the owner’s equity prepared above and assume that Kebede wants to join Lidia and Abebe, and they have accepted Kebede’s request.Kebede has admitted to Style closing partnership by purchasing 10% of Lidia’s capital for Br3000 cash and 8% of Abebe, capital for Br 1000 cash 6 The journal entry to record Kebede’s admission would be: The amount of capital purchased by Kebede is: From Lidia…………….10% of 30,350 Br3, 035 From Abebe…………….8% of 39750 3180 Total…………………………………………. Br 6215 Hence, Lidia, capital ………………..3035 Abebe, capital…………........3180 Kebede, capital………………6215 (To record kebede’s admission) As we have said earlier, when admission is made by purchasing the capital of the existing partner; there will be no effect on both total capital and total assets of partnership. This can be proved as follows: Lidia Abebe Kebede Total Capital before admission…………..30,350 39,750 70,100 Admission………………………… (3,035) (3,180) 6,265 0 Capita after admission………… 27,315 36,570 6,215 70100 As we can see from the above analysis, the capital before admission and after admission is the same. Admission by Investing Assets: The admission of a partner by investing assets is a transaction between the new partner and partnership. The transaction increases both the total assets and total capital of the partnership. To record such admission the invested asset is debited by its current market value and the capital of entering partner will be credited. \ Example: Assume the previous example, instead of purchasing capital from the existing partners, Kebede was admitted to Style Closing partnership by investing Cash of 10,000 Br and Land having current market value of 15,000 Br. The entry to record Kebede’s admission will be: Cash ……………….10, 000 Land ………………..15,000 Kebede’s capital………..25,000 After Kebede’s admission, the total capital balances as well as total assets balance of the Style closing partnership will increase by Br 25,000. Withdrawal of a partner The withdrawal of a partner, like admission of a partner, legally dissolves the partnership. As indicated earlier, the partnership agreement should specify the terms of withdrawal. There are different ways that a partner may withdraw. Sell their interest to another partner(s) with the other partner(s)’ consent. Sell their interest to an outsider with the consent of the other partner(s). Withdraw assets equal their capital balances. When the remaining partner purchase the capital of withdrawing partner, it is exactly opposite to admission by investing assets but similar to admission by purchasing capital. Because the transaction does not affect both the total capital and the total assets balances of the business. The entry to record such 7 withdrawal is removing the capital balance of the withdrawing partner and replacing it with remaining partner’s capital. If the drawing partner is paid his capital balance by the business, definitely both the capital as well as the asset of the business will decrease. Note that when withdrawal is to be made, net income up to the date withdrawal has to be computed and distributed to each partner .In addition, assets should also be revalued to their current market value and the net effect of revaluation has to be adjusted to each partner’s capital based on their income or loss sharing ratio. Finally, the leaving partner will be paid his or her updated capital balance. Example: Assume that, as of December 31, 1991, Lidia wants to withdraw from her partnership. As of this day, the updated capital balances of the partners are as follows: Lidia, capital……………...Br100,000 Abebe, capital ………………150,000 Kebede, capital ……………. 120,000 If Lidia withdraws in the following manner, the entries to record her withdrawal would be: i. Lidia has withdrawn by selling her capital to Abebe and Kebede .Abebe purchased 40% for 45,000 cash and Kebede the 60 % for 62, 000 cash. ii. The business has paid Lidia her capital balance. Solution As per this assumption, the remaining partners have purchased her capital and the transaction is again personal .Therefore the journal entry required on the book of the partnership is simply transferring the capital of leaving partner to the remaining partner regardless of the amount paid by Abebe and Kebede. Lidia, capital……….100, 000 Abebe, capital…………… 40,000 Kebede, capital………….. .60, 000 In this case, the business has paid her capital balance i.e. the transaction is between the business and the leaving partner, hence, her withdrawal reduces both the assets and capital of the business. Lidia, capital………….100, 000 Cash…………………100,000 Partnership Liquidation The liquidation of the partnership terminates the business. This may be...
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