Accounting for Partnerships Flashcards
K. Nasser and T. Yoko are considering a business venture. They ask you to explain the advantages and disadvantages of the partnership form of organization.
The advantages of a partnership are: (1) combining skills and resources of two or more individuals, (2) ease of formation, (3) relatively free from governmental regulations and restrictions, and (4) ease of decision-making. Disadvantages are: (1) mutual agency, (2) limited life, and (3) unlimited liability.
Gurprinder and Harjinder decided to form a partnership and operate a business together. Harjinder is much more cautious and concerned about keeping expenses to a minimum than Gurprinder. Harjinder also has significantly more personal assets than Gurprinder. Should Harjinder have any concerns about using the partnership form of business organization to operate this business? Explain.
Each partner is jointly and severally liable for all partnership liabilities. Harjinder should be concerned with the possibility that the business does not succeed and there are insufficient assets to pay all debt outstanding. If this happens, the creditors could then make claims against the personal assets of the partners. In this case, Harjinder has more assets to lose than his partner Gurprinder, who is less cautious about handing expenses.
Because of concerns over unlimited liability, there are now special forms of partnership organization that modify that characteristic. Describe these other forms of partnership.
Other forms of partnership organization include limited partnerships and limited liability partnerships. In a limited partnership, one or more of the partners have unlimited liability. This type of partner is called a general partner. General partners are normally actively involved in the business. One or more other partners, called limited partners, have liability that is limited to the amount of capital they have contributed to the partnership. Normally, limited partners contribute assets to the business but are not actively involved in it.
Limited liability partnerships are designed to protect innocent partners from actions of the other partners that result in lawsuits against the partnership. Partners have unlimited liability for their own negligence but limited liability for negligence of the other partners.
(a) What items should be specified in a partnership agreement?
(b) Why is it important to have this agreement in writing?
(a) The partnership agreement should contain basic information such as the name and location of the firm, the purpose of the business, and the date of inception. In addition, the agreement should specify the names and capital contributions of the partners, the rights and duties of the partners, the basis for sharing profit or loss, provisions for withdrawal of assets, procedures for settling disputes, procedures for withdrawal or admission of a partner, the rights and duties of a surviving partner if a partner dies, and procedures for liquidating a partnership.
(b) If a partnership agreement is not written, the provisions of the Partnership Act will apply to the partnership. This could include equal sharing of profit and loss, amongst other provisions, which may not meet the requirements and needs of the partners.
(a) For accounting purposes, when a partner invests assets in a partnership, how is the value of these assets determined?
(b) Is this practice consistent with the cost principle? Explain.
(a) The value of the partners’ investment would equal the fair value of the contributed assets at the date of their transfer to the partnership.
(b) This is consistent with the cost principle because fair value represents the cost, or amount given up by the partnership, to acquire these assets.
When a partnership is formed, one or more of the partners may contribute equipment as part of their initial investment. How is the amount of accumulated depreciation to be recorded on this equipment determined?
When a partner contributes equipment as his initial investment, any depreciation that has accumulated on the equipment and recorded in a previous business is not part of the investment transaction. Since the equipment is invested into a new business at its fair value, the investment is treated the same way as the purchase of a used asset. The equipment has not yet been used by the partnership so there is no accumulated depreciation.
Franca and Naheed are transferring $8,000 of accounts receivable from each of their sole proprietorships into a partnership. They have agreed that $7,000 of Franca’s receivables is collectible but it is likely they will collect only $6,000 of the receivables from Naheed’s proprietorship. How should these receivables be recorded in the partnership? Explain why.
When the accounts receivable are transferred into the partnership, they should be recorded at their realizable value. In the case of Naheed’s accounts receivable, although they total $8,000 their realizable value is only $6,000. Consequently, the amount recorded as accounts receivable will be the full $8,000 but that amount will be reduced by an allowance for doubtful accounts of $2,000 in Naheed’s investment entry. Similarly, Franca’s accounts receivable should be recorded at $8,000 but reduced by the allowance for doubtful accounts amount of $1,000 for a net realizable value of $7,000.
S. Hark and R. Green are discussing how profit and losses should be divided in a partnership they plan to form. They think they should wait to see who has worked the hardest before agreeing on how to share the profit. What are the advantages and disadvantages of doing this?
Hark and Green should not wait to see who has worked the hardest before agreeing on how to share the profit of their partnership. Although this allows for the flexibility of using hindsight in applying some sort of salary allowance formula in their profit allocation, it also has the disadvantage of allowing a dispute to happen in the future, at which time there will be no opportunity to rectify the agreement on profit allocation.
What is the relationship between (a) a salary allowance for allocating profit among partners and (b) partners’ cash withdrawals?
There is no direct relationship between a salary allowance for allocating profit among partners and partners’ cash withdrawals. While withdrawals reduce the capital balance of a partner, they are not used in profit allocation formulas, the way salary allowance can be used. A salary allowance is used when allocating profit to the partners and is intended to reward a partner for efforts he puts forth for the business.
What is the difference between a salary allowance for allocating profit among partners and salary expense? Between an interest allowance and interest expense?
Salary expense and interest expense are elements of the income statement and represent reductions of profit before it is allocated to the partners. Salary allowance and interest allowance are part of the process of allocating the profit to the partners, and are not elements of the income statement. Salary allowance is a means of recognizing levels of effort put forth by the partners in earning profit. Interest allowance rewards partners for their levels of investment in the partnership, based on the capital account balances.
What is included in a statement of partners’ equity? How is it similar to, and different from, a statement of owner’s equity?
The statement of partner’s equity has the same content as the statement of owner’s equity except that it contains the details of all the changes in each partner’s capital as well as the changes in total for the partnership. These changes include: investments, profits, losses and drawings.
The income statement of a partnership includes the details of how the profit or loss is divided among the partners. Do you agree or disagree? Explain.
The statement of income of a partnership does not include the details of how the profit or loss is divided among the partners. Instead, the statement of partners’ equity is used to show this information.
The equity section of a partnership’s balance sheet shows the total amount invested by the partners separate from the profit earned to date and retained in the business. Do you agree or disagree? Explain.
The equity section of a partnership’s balance sheet does not show the total amount invested by the partners separate from the profit earned to date and retained in the business. Rather, that distinction for the current fiscal year (between investments and profit) is outlined in the statement of partners’ equity. Once added (or deducted in the case of a loss) to each partner’s capital account balance, the distinction between the sources of changes is no longer tracked in the subsequent financial statements of the partnership. Only the balances of the capital accounts of each partner carry forward to the next fiscal year.
How is the accounting for admission to a partnership by purchase of a partner’s interest different from the accounting for admission by an investment of assets in the partnership? In your explanation, also include how the net assets and total capital change after the admission of a partner in each of these two ways.
When an admission of a new partner into a partnership occurs as a result of a purchase of an existing partner’s interest, the net assets and corresponding total partners’ equity of the partnership will remain unaffected. If the interest is purchased with an additional investment of assets in the partnership, net assets and corresponding total partners’ equity will increase by the amount of the investment.
R. Minoa decides to invest $25,000 in a partnership for a one-sixth capital interest. Will Minoa’s capital balance be $25,000? Does Minoa also acquire a one-sixth profit and loss ratio through this investment?
Partnership net assets increase $25,000. R. Minoa’s capital balance will not necessarily be $25,000. No, R. Minoa does not necessarily acquire a 1/6 profit and loss ratio. Profit and loss will be divided according to what is stated in the partnership agreement. If no division is specified, profit or loss is divided evenly.
