Ch 14 Partnerships Flashcards
What is the wide size range of business activities the partnership form serves?
Small local operations to worldwide enterprises
What does the IRS project the number of partnership income tax returns will be compared to corporate returns by 2016?
4.7 million partnership returns
Compared to 8.1 corporate income tax returns
Why do individual proprietors join together to form a partnership? 4 reasons
1 reduce expenses
2 expand services
3 add increased expertise
4 tax benefits
Partnership is a common means by which friends and relatives can…
Easily create and organize a business endeavor
Historically, why have doctors, lawyers and other professionals formed partnerships?
legal prohibitions against incorporation of their practices
Most common motive to form a partnership (instead of a corporation)
Ease of formation
What is necessary to create a legally binding partnership?
Only an oral agreement
Depending on specific state laws, incorporation requires filing a…
Formal application and completing various other forms and
Documents
Partnership revenue and expense items (as defined by tax laws), where must they be assigned?
Must be directly assigned each year to individual partners who
Pay income tax
Passing income balances through to partners, avoids what?
Double taxation of profits earned by business
And then passed through to owners
How is a corporation’s income taxes twice?
1 when earned
2 when paid as dividend
A partnership’s income is taxed only at the time the…
Business initially earns it
Historically, what is the second tax advantage (after flow through income) associated with partnerships?
Operating losses can reduce personal taxable income directly
Corporations: operating losses, disadvantage
Corporation is viewed as legally separate from its owners
So losses can’t be passed through to owners
Corporations: operating losses, 2 advantages
1 carry back net operating losses 2 years to reduce previously
Taxed income
2 carry forward remaining losses 20 years to reduce future
Taxable income
Newly formed corporation VS. Newly formed partnership: operating losses
If corporation is newly formed or hasn’t been profitable, operating
Losses provide no immediate benefit to corporation/owners
Losses provide immediate benefit to partnership
Limitation of tax advantage of deducting partnership losses: passive activity limitation
Passive activity losses serve only to offset passive activity profits
For tax purposes, ownership of a partnership is labeled as passive activity unless…
The partner materially participates in the actual business activities
In most cases, passive activity partnership losses can’t be used to reduce…
Earned income (ex. Salaries)
Unless a taxpayer has significant passive activity income (ex. From rents), losses reported by partnership create…
Little or no tax advantage unless partner materially participates
In actual business activity
Most significant disadvantage of partnership
Unlimited liability each partner incurs
Unlimited liability specified by partnership law?
Any partner can be held personally liable for all debts of business
Mutual agency
Right each partner has to incur liabilities in name of partnership
Consequence of mutual agency: partners acting within normal scope of business have the power to…
Obligate the company for any amount
What happens if the partnership fails to pay any debts incurred in mutual agency?
Creditors can seek satisfactory remuneration from any partner
They choose
Uniform Partnership Act (UPA) (1914, revised 1997), where and how has it been adopted?
By all states in some form
Uniform Partnership Act, establishes uniform standards in what 3 main areas?
1 nature of partnership
2 relationship of partners to outside parties
3 dissolution of partnership
Uniform Partnership Act (UPA): Section 6’s legal definition of a partnership
Association of 2 or more persons to carry on business as
co-owners for profit
Because of the possible owner liability, partnerships often experience difficulty in attracting…
Large amounts of capital
2 main Purposes of alternative legal forms of partnership
1 limit owners’ personal liability
2 provide tax benefits of partnership
S corporation
Has legal characteristics of corporation
Taxed as partnership, where profits are only taxable to individual
Owners
What are the 2 main advantages of an S corporation?
1 form avoids double taxation
2 owners don’t face unlimited liability
How can a business qualify as an S corporation? 3
1 one class of stock 2 shareholders limited to 100 3 restrictions on types of owners
S-Corp: restrictions on types of owners
All owners must be individuals, estates, certain tax-exempt
Entities or certain trusts
What is the most significant problem with the S-Corp form of business?
Growth potential is limited because restriction on number and
Type of owners
Limited partnership (LP)
Type of investment designed primarily for individuals who want
The tax benefits of partnership
But who don’t work in a partnership or have unlimited liability
Limited partners
Can invest money as owners, but not allowed to participate in
Company’s management
Limited partners: loss on money invested in business
Restricted to amount they’ve contributed
How are creditors of a limited partnership protected?
1 or more general partners have responsibility for all obligations
Created in name of business
Why are many partnerships originally formed?
As tax shelters to create immediate losses (reducing taxable
Income for partners) with profits spread to the future
Tax laws limit the deduction of passive activity losses and this significantly reduced…
The formation of limited partnerships
Limited liability partnership (LLP) 2 things
1 Has most characteristics of general partnership
2 Except it significantly reduces partners’ liability
What are partners liable for in a limited liability partnership?
Their investment in the business and contractual debts of the
business
Limited liability partnerships: liability resulting from damages
Partners only responsible for their own acts or omissions
And acts and omissions of those under supervision
Ex. A partner in Houston office won’t be held liable for a poor audit from the San Fransisco Audit team,
Limited liability partnerships have become…
Very popular with professional service organizations with multiple
Offices
Ex. All big four are LLPs
Limited liability company’s (LLCs)
Classified as partnership for tax purposes
Depending on state laws, owners risk only their own investments
Advantage of an LLC over an S Corp
Number of owners is not restricted
So growth is easier to accomplish
What 2 questions should be raised as to the need for an entirely separate study of partnership accounting?
1 does an association of 2 or more persons require accounting
Procedures significantly different from corporations?
2 Does proper accounting depend on legal form of an organization?
What 4 accounts are accounting procedures normally standardized for regardless of legal form of business?
1 assets
2 liabilities
3 revenues
4 expenses
Partnership accounting does exhibit unique aspects that warrant study, but they lie primarily in the…
Handling of partners’ capital accounts
Stockholder equity accounts of a corporation do not correspond directly with…
Capital balances on partnership’s financial records
The various equity accounts reported by an incorporated enterprise display…
A greater range of info than partnership capital accounts
Government regulation has had an enormous effect on accounting for corporate equity transactions in that…
Extensive disclosure is required to protect stockholder’s and
Outside parties
How do partnerships provide only a limited amount of equity disclosure?
Primarily in form of individual capital accounts that are accumulated For every parter/class of partners
Partners individual capital account balances, what do they measure?
Each partner’s/groups’ interest in book value of net assets of
business
The equity section of a partnership balance sheet is composed solely of capital accounts that can be affected by different events 4
1 contributions from partners
2 distributions to partners
3 earnings
4 other equity transactions
Articles of partnership
Legal covenant (either oral or written)
Forms central governance of partnership’s operation
Articles of partnership, what do they provide rather than laws or official rules?
Much of underlying basis of partnership accounting
Spell out guidelines for financial arrangements and various
Capital transactions
How are the articles of partnership created?
Negotiated agreement partners create
Differences caused by articles of partnerships between businesses?
Partners’ rights and responsibilities differ from business to business
Firms often hire accountants in an advisory capacity to participating in creating the articles of partnership to ensure…
Equitable treatment of all parties
Articles of partnership, provisions that must be reached:
1) name and address of…
Each partner
Articles of partnership, provisions that must be reached:
2) Business…
Location
Articles of partnership, provisions that must be reached:
3) description of nature…
Of business
Articles of partnership, provisions that must be reached:
4) rights and responsibilities of…
Each partner
Articles of partnership, provisions that must be reached:
5) initial contribution to be made by…
Each partner and method to be used for valuation
Articles of partnership, provisions that must be reached:
6) specific method by which profits and losses are…
To be allocated
Articles of partnership, provisions that must be reached:
7) periodic withdrawal of…
Assets by each partner
Articles of partnership, provisions that must be reached:
8) procedure for admitting…
New partners
Articles of partnership, provisions that must be reached:
9) method for arbitrating…
Partnership disputes
Articles of partnership, provisions that must be reached:
10) life insurance provisions enabling remaining partners to…
Acquire interest of any deceased partner
Articles of partnership, provisions that must be reached:
11) method for settling partner’s share in business upon…
Withdrawal, retirement or death
If carter invests 50k and green invests 20k in cash what is the journal entry to record starting a partnership?
Cash. 70,000
Carter, Capital. 50,000
Green, Capital. 20,000
According to the concept of unlimited liability, a partnership does not exist as…
An entity apart from its owners
Each item transferred to a partnership is initially recorded for external reporting purposes at…
2) for tax purposes, what should be kept track of?
Current value
2) basis of transferred asset
What are 2 examples of how a partnership can be viewed legitimately as an entity apart from its owners?
Partnership maintains legal ownership of its assets
And can initiate lawsuits
Accounting practice traditionally has held that the contribution of assets (and liabilities) to a partnership is an exchange between…
2 separately identifiable parties that should be recorded based on
Fair values
3 purposes appropriate valuation of each capital balance serves over the life of the partnership
1 totals in individual capital accounts influence assignments of
Profits/losses to partners
2 capital account balance usually factor in determining final
distribution by partner at time of withdrawal/retirement
3 ending capital balances indicate allocation of any assets that
Remain following liquidation of partnership
After a partner contributes assets such as inventory, land or a building, the partner…
Holds no further right to these individual assets
They belong to the partnership
A capital balance of a partner represents what?
An ownership interest in the business as a whole
Not a claim to any specific asset
Intangible contributions to a partnership
Formal accounting recognition of such special contributions
May be appropriately included in provision of partnership agreement
2 options of methods that can be used to record an intangible contribution?
1 bonus method
2 goodwill method
What do the bonus method and goodwill method each do?
2) what will happen depending on the method selected?
Achieve the desired result of establishing equal capital account balances
2) significant variation in recorded figures
Bonus method
Assumes specialization (such as artistic abilities) does Not constitute a recordable partnership asset with measurable cost
Recognizes only assets transferred to business (such as cash,
Patents or inventory)
Goodwill method
Based on assumption an implied value can be calculated
And recorded for any intangible contribution made by partner
Partnership goodwill: how does it differ from goodwill recognized using the equity method?
Partnership goodwill has no historical cost
The business recognizes asset of goodwill even though no funds
Have been spent
The value attributed to goodwill is based solely on…
Negotiated agreement between the partners
Partnership goodwill should be viewed with a strong degree of…
Professional skepticism
Subsequent to forming a partnership, what are 2 common reasons owners may choose to contribute additional capital amounts during the life of the business?
1 stimulate expansion of business
2 overcome working capital shortages
Articles of partnerships-withdrawals:
To protect the interests of the other partners, the articles of partnerships should clearly specify…
The amount and timing of such withdrawals
Articles of partnership may require prior approval of other partners
Articles of partnership often allow withdrawals on a…
Regular periodic basis
What is the journal entry to record a withdrawal from the partnership of James of $1,200?
James, Drawing. 1200
Cash. 1200
Allocation of income
At the end of each fiscal period, partnership revenues and
Expenses are closed out
Accompanies by allocation of resulting net income/loss to
Partners’ capital account
If no arrangement exists from the articles of partnership of how income is allocated, what does state partnership law normally hold?
All partners receive equal allocation of income/loss from business
Allocation pattern can be extremely important to the success of an organization because it can help…
Emphasize and reward outstanding performance
From an accounting perspective, the assignment of income and the setting of withdrawal limits are…
2 separate decisions
What is the journal entry to close out the drawing accounts regarded by payments made to 2 partners?
Tinker, Capital. 10000
Evers, Capital. 10000
Tinker, Drawing. 10000
Evers, Drawing. 10000
How is net income allocated between 3 partners based on provisions of partnership agreement: journal entry
Income summary. 60000
Tinker, Capital (30%). 18000
Evers, Capital (40%). 24000
Chance, Capital (30%). 18000
Statement of partners capital
Statement of retained earnings usually reported by corporation
Is replaced by statement of partners’ capital
Outlines current year changes of capital accounts
Any alteration in the specific individuals composing a partnership automatically leads to…
Legal dissolution
If dissolution of partnership takes place, actual operations of business would probably…
Continue up impeded by this alteration in ownership
Liquidation of partnership, what 3 things occur?
1 partnership sells properties
2 pays debts
3 distributes remaining assets to individual partners
2 ways an individual can gain admittance to a partnership
1 purchasing an ownership interest from a current partner
2 contributing assets directly to business
Dissolution-admission of a new partner, in recording this transaction what 2 options does the accountant have?
1 retain book value of all partnership assets and liabilities
(Bonus method)
2 revalue accounts to present fair values (goodwill method)
For recording dissolution to acquire a new partner, the decision as to the theoretical preference between bonus and goodwill method hinges on what one single question?
Should the dissolved partnership and newly formed partnership
Be viewed as 2 separate reporting entities?
Dissolution- admission of a new partner:
If new partnership is merely an extension of the old…
No basis exists for restatement
Dissolution- admission of a new partner:
If the combination of business represents a legitimate transfer of property from one partnership to another…
Revaluation of all accounts and recognition of goodwill can be
justified
Problem with partnership goodwill, 2 things
1 Recognition is not based on historical cost
2 no objective verification of capital amount can be made
Hybrid method (between bonus method and goodwill method)
Revalues all partnership assets and liabilities to fair value without
Making any corresponding recognition of goodwill
One it more partners can choose to sell their portion of business to outside party.
When is this type of transaction more common?
More common in operation that rely primarily on monetary
Capital (rather than business expertise of partners)
In making transfer of ownership, what 3 rights can a partner only convey?
1 right of co-ownership in business property
2 right to share in profits and losses as specified in articles of
Partnership
3 right to participate in management of business
Right of co-ownership in the business property
Justifies the partner’s periodic drawings from the business
And distribution settlement paid at liquidation or time of partner’s
Withdrawal
The right to participate in management of business
Can be done only with consent of all partners
Essential to future earning power of enterprise and maintenance
Of business assets
The right of co ownership in the business property and right to share in profits and losses as specified in articles of partnership, when can these 2 rights be assigned?
At any time partner decides to leave
If a partner decides to leave the partnership and sell his interest to someone who is not yet a partner, when does the new owner become a partner?
Not until the other existing partners allow the new owner to
Participate in management of the business
Relationship of capital accounts often does not correspond with…
2) capital balances are…
Partners’ profit and loss ratio
2) historical cost figures
Capital balances, what do they result from?
Contributions and withdrawals made throughout life of business
And from allocation of partnership income
The book value method is similar to…
The bonus method
What is another name for the Goodwill Method?
Revaluation method
Bonus credited to new partner
Difference between amount contributed and capital allotted is
Viewed as bonus
The implied value of a partnership as a whole cant be determined directly from the amount…
Distributed to a withdrawing partner
