Week 12(1) (2)

CHAPTER 8Partnerships:

formation, operation and reporting

LEARNING OBJECTIVES

1. Define a partnership and the major attributes of a partnership2. State the advantages and main characteristics of the partnership

structure of a business3. Explain the purpose of a partnership agreement and describe its

typical content4. Describe the special features applicable to accounting for partnerships5. Explain the accounting entries for the formation of a partnership6. Explain the accounting entries for the allocation of profits of a

partnership7. Explain the accounting entries for drawings and advances or loans

made by partners8. Describe the content of the financial statements of a partnership

PARTNERSHIP DEFINED

• Partnership Act:– The relationship that ‘subsists between persons

carrying on a business in common with a view to profit’

• Necessary attributes1. Must be an agreement (written or verbal)2. View to earning a profit3. Co-ownership of the business

ADVANTAGES OF A PARTNERSHIP

• Pooling of capital resources and multiple skills of individual partners

• Formed at little or no cost• Subject to little regulation/supervision• Partners may be able to operate with more

flexibility because not subject to control of a board of directors

• May be tax advantages

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

• 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/day to day operations– Withdrawals (drawings)– Dispute resolution– Admission/withdrawal of partners– Partnership liquidation

ACCOUNTING FOR A PARTNERSHIP

• Accounting is mostly the same as already presented for a sole trader

• The major difference is around accounting for the partners’ equity– Ownership interests are generally not equal• Capital investment and drawings vary• Profit distributed according to partnership agreement

• Two commonly used methods of accounting

METHOD 1: FLUCTUATING CAPITAL ACCOUNTS (The one we are doing)

• Capital account credited when assets are invested in the partnership

• 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– In agreed ratio, usually as per agreement

METHOD 2: FIXED CAPITAL ACCOUNTS

• Capital account credited with asset 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• Commonly used in practice

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 price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at measurement date

ACCOUNTING FOR THE FORMATION OF A PARTNERSHIP

• Assuming that the partners agree to have capital balances equal to the fair value of net assets contributed and that GST is not applicable the initial entry would be:

General Journal

Jun 30 Assets X

Liabilities X

Partner A, Capital X

(Assets and liabilities contributed by Partner A to the partnership)

ALLOCATION OF PARTNERSHIP PROFITS AND LOSSES

• Consider for each partner:– services performed– capital invested– business risk assumed

• Common methods– fixed ratio– ratio based on capital balances– fixed ratio allowing for interest and salary

ALLOCATION OF PROFIT:FIXED RATIO

• Method 1 – Fluctuating Capital Accounts• Assuming the partners (Becker and Cook) agree

to a 7:3 sharing of profitsGeneral Journal

Jun 30 P&L Summary 60 000Profit Distribution 60 000

(Transfer of profit to distribution account)

Profit Distribution 60 000M. Becker, Capital 42 000R. Cook, Capital 18 000

(Distribution of profit to partners)

ALLOCATION OF PROFIT: RATIO BASED ON CAPITAL BALANCES

• Used where invested capital is considered most important factor and/or the operations require little of the partners’ time

• Assuming ratio is calculated based on beginning capital balances:

Capital Investment

Profit Allocation

Becker $150 000 ($150 000/$250 000) x $60 000 $36 000Cook 100 000 ($100 000/$250 000) x $60 000 24 000

Totals $250 000 $60 000

ALLOCATION OF PROFIT: RATIO BASED ON CAPITAL BALANCES

• Method 1General Journal

Jun 30 P&L Summary 60 000

Profit Distribution 60 000

(Transfer of profit to distribution account)

Profit Distribution 60000

M. Becker, Capital 36000

R. Cook, Capital 24000

(Distribution of profit to partners)

ALLOCATION OF PROFIT: FIXED RATIO AFTER INTEREST AND SALARIES

• Used where partners make unequal capital contributions and the amount of time and the nature of services performed are not the same.

Becker Cook TotalInterest on Capital

$150 000 x 10% $15 000$100 000 x 10% $10 000 $25 000

Salaries to partners 18 000 10 000 28 000Total interest and salary 33 000 20 000 53 000Residual divided equally 3 500 3 500 7 000

Equity Increase $36 500 $23 500 $60 000

ALLOCATION OF PROFIT: FIXED RATIO AFTER INTEREST AND SALARIES

• Method 1General Journal

Jun 30 P&L Summary 60 000

Profit Distribution 60 000

(Transfer of profit to distribution account)

Profit Distribution 25000

M. Becker, Capital 15000

R. Cook, Capital 10000

(Distribution of interest on capital to partners)

ALLOCATION OF PROFIT: FIXED RATIO AFTER INTEREST AND SALARIES

• Method 1General Journal

Jun 30 Profit Distribution 28 000

M. Becker, Capital/Retained Earnings 18 000

R. Cook, Capital/Retained Earnings 10 000

(Distribution of salaries to partners)

Profit Distribution 7 000

M. Becker, Capital 3 500

R. Cook, Capital 3 500

(Distribution of residual profit to partners)

DRAWINGS MADE BY PARTNERS

• Partners may withdraw cash or other assets from the partnership.

• Drawings may be from earnings or capital• Under method 1 there is no distinction.

General Journal

Partner A, Drawings X

Cash at Bank or Other Asset X

(Cash or asset drawing by Partner A)

DRAWINGS MADE BY PARTNERS

• Method 1 - Closing drawings accountGeneral Journal

Jun 30 Partner A, Capital X

Partner A, Drawings X

(Closing entry for drawings)

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Accounting for Drawings Method 1General Journal

Dec 31 Becker Drawings 14,000Cash at Bank 14,000

(Cash drawings by Becker)Mar 31 Cook Drawings 8,000

Cash at bank 8,000(Cash drawings by Cook)

Jun 30 Becker Capital 14,000Cook Capital 8,000 Becker Drawings 14,000 Cook Drawings 8,000(Closing entry for partner withdrawals)

INTEREST ON DRAWINGS

• Partners may agree to pay interest on drawings of profits or capital

• This provides an incentive to retain investment in the partnership (and disincentive to withdraw)

General Journal

Jun 30 Partner A, Capital X

Profit Distribution X

(Charging interest on drawings)

LOANS OR ADVANCES BY PARTNERS

• Partners may lend money to the partnership on a short term basis rather than investing

• This represents a liability of the partnershipGeneral Journal

Cash at Bank X

Advance from Partner A X

(Advance from partner)

Interest Expense X

Cash at Bank / Interest Payable X

(Interest on partner advance)

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ALLOCATION OF PROFIT: FIXED RATIO AFTER INTEREST AND SALARIES, &

INTEREST ON DRAWINGS• Used where partners make unequal capital contributions and the

amount of time and the nature of services performed are not the same. Becker Cook Total

Interest on Capital credited$150 000 x 10% $15,000$100 000 x 10% $10,000 $25,000

Salaries to partners credited 18,000 10,000 28,000Interest on drawings debited *(560) *(160) (720)

32,440 19,840 52,280Residual divided equally 3,860 3,860 7,720

Equity Increase $36,300 $23,700 $60,000

*Interest of 8% pa on drawings. Becker 14000*.08*6/12. Cook 8000*.08*3/12

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 (or Statement of Changes in Equity)

FINANCIAL STATEMENTS FOR A PARTNERSHIP

• Salaries, interest on capital and interest on drawings are not expenses– Allocation of profit

• No income tax expense because partnership is not a legal entity and not subject to tax

• Profit or loss allocation disclosed in a separate statement of changes in partners’ equity

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STATEMENT OF CHANGES IN PARTNERS’ EQUITY

BC PARTNERSHIPStatement of Changes in Partners’ Equity

For the year ended 30 June 2015

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Attempt this problem-Construct a profit allocation table

• Kerrie & Connie are in a partnership sharing profits equally. The partnership agreement allows for Kerrie to receive a $60,000 salary and Connie to receive a $50,000 salary. Interest is also charged on closing capital balances of 8% p.a. and interest on drawing balances of 10% p.a.

• The capital and drawings accounts are as below:

Kerrie ConnieCapital 96 000 Capital 108 000

Drawings 24 000 Drawings 30 000

• Profit before allowing for interest was $144,000• All drawings made in expectation of profits

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ALLOCATION OF PROFIT: FIXED RATIO AFTER INTEREST AND SALARIES, &

INTEREST ON DRAWINGS

Kerrie Connie TotalInterest on Capital credited

$ x 8%$ x 8%

Salaries to partners creditedInterest on drawings debited x 10%Residual divided equally

Equity Increase

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Reminder

• Submit your Accounting Practice set assignment on due time

• Attend MYOB tutorial in computer lab (part of the minimum attendance requirement in this unit)

• Review lecture in week 13 (week 6-10)• Review lecture in week 14 (week 11-12)• Review Tutorial in week 14