Partnership

1. Partnership:

1. Explain the process and methods used to account for partnership formation. How do these methods impact the firm’s balance sheet?

The articles of partnership are a legal covenant that can be oral or written, which detail the rules for countless capital transactions. Typically such agreements facet the name of the firm and identify the partners, the nature, scope and purpose of the firm as well as the allocation of profit or loss.  It should also detail the salaries/withdrawals of assets and the rights, duties and obligations of each partner.  

A general partnership is a joint agency where each partner shares an unlimited liability and the right to dispose of their partnership interest.  In a limited partnership, a limited partner, or partners, invest capital only and are held liable for only the amount invested.  Limited partners do not manage the day to day operations of the firm.

The methods used to account for partnership formation are the bonus method and the goodwill method.  Under the bonus method, if the amount invested by the new partner is larger than book value it is allocated to the old partner(s).  Whereas, if it is less than book value it is allocated to the new partner(s). Essentially, any difference between the partner’s investment and book value is a bonus and distributed to all partners.

The goodwill method should be viewed with skepticism because any difference between the partner(s) investment and book value is recorded as goodwill, an intangible asset on the balance sheet.

“The equity section of a partnership balance sheet is composed solely of capital accounts that can be affected by many different events.”  (Hoyle, et al.)  The admission of new partners; the retirement, withdrawal or death of a partner; or any earnings or losses will impact the balance sheet of the firm.

The original investment of each partner is recorded as a credit to the capital accounts at current fair value, and a debit to cash or another asset account.  Any withdrawals of cash or other assets by partners in anticipation of net income are considered salary allowances and are recorded as a debit to the drawing account.

On occasion, a partnership may loan a partner funds, which it expects to be repaid.  This would result in a debit to loans receivable from partners account rather than the partner’s drawing account.  Alternatively, a partner may loan money to the partnership that would result in a credit to the loans payable to partners account, rather than an increase to that partner’s capital account.

1. Illustrate how the company could split profits and losses.

“The Uniform Partnership Act provides that if partners fail to specify a plan for sharing net profits and losses, it is assumed that they intend to share equally.”  (Larsen)  With that said, income ratios should be specified in the partnership agreement providing the basis for sharing net profit or loss.  There are numerous possibilities for the division of net income or loss, also known as income ratios, all of which are recognized in the capital accounts through closing entries.  Typical income ratios may be:

1. Equally, or in some other ratio
2. In the ratio of partners’ capital account balances on a particular date, or in the ratio of average capital account balances during the year
3. Allowing interest on partners’ capital account balances and dividing the remainder on a fixed ratio
4. Allowing salaries to partners and dividing the resultant in a specified ratio
5. Allowing salaries to partners, interest on capital account balances and dividing any remaining net income or loss in a fixed ratio

Please see Appendix A

1. Describe what happens if the partnership doesn’t do well and the company has to dissolve it, or one of the partners becomes insolvent.

The Uniform Partnership Act lists the order for distribution of cash as 1) payment of creditors in full; 2) payment of loans from partners, and 3) payment of partners’ capital account credit balances.  “In many instances, the breakup is merely a prerequisite to the formation of a new partnership.” (Hoyle, et al)  Regardless of why a partnership dissolves, the fundamental goal is to determine the gain or loss on realization of noncash assets before distribution to the partners.  The partnership should prepare adjusting entries and financial statements for the final accounting period prior to dissolution.  Only balance sheet accounts should be open as the liquidation process begins.

Let’s revisit the partnership of Adams & Brooks from above.  Assume the balance sheet appears as follows:

Adams & Brooks

Balance Sheet as of December 31, 2015

Step 1 requires the noncash assets with a carry amount of $75,000 be realized, we will determine to be $35,000, resulting in a loss of $40,000 to be absorbed equally.  Because Brooks’ capital account balance is only $5,000, we exercise the right of offset by transferring $15,000 from Brooks’ loan account to his capital account.  The statement of realization and liquidation will show the division of the realization of loss between the partners, the payment to creditors, the offset of Brooks’ loan to his capital account and the distribution of any remaining cash to the partners.  

In the statement of realization and liquidation, Brooks’ loan account balance of $20,000 and capital account balance of $5,000 might have been combined to obtain an equity of $25,000 for Brooks. This is done because the partner’s loan account has no significance in determining either the total amount of cash paid to a partner or the timing of cash payments to partners during liquidations.

Neither partner receives cash until after the creditors have been paid in full.

When one partner becomes insolvent, they incur a deficit in their capital account.  During dissolution or liquidation, the remaining partners must absorb the deficit as an additional loss to be shared in the same proportion as they have previously shared any profit or loss.