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Objectives: Identify the characteristics of a partnership. Account for initial equity invested by the partners. Account for changes in equity brought about by profit share and drawings
ACCG204 Lecture Two Accounting for Partnerships 1 Objectives 1. Identify the characteristics of a partnership. 2. Account for initial equity invested by the partners. 3. Account for changes in equity brought about by profit share and drawings Objective 1 Identify the characteristics of a partnership. Characteristics of a Partnership Definition of a partnership – from the Partnership Act. “A partnership is an association of two or more persons carrying on business in common with a view to making a profit.” Forming a partnership requires no legal procedures. It can be formed simply by a verbal agreement to go into partnership together. But usually a partnership agreement is drawn up. Advantages and disadvantages A partnership arrangement has the following advantages over a sole trader business: More capital Wider skill base Sharing of workload On the other hand, profits are shared and there may be disagreements and disputes among partners, personal or business related. What distinguishes a partnership? Written or verbal agreement – – – The partners may have a written partnership agreement or they may simply have a verbal agreement. A partnership agreement (deed of partnership) is a contract between the partners, so it is covered by contract law. It describes the business and clarifies such points as profit sharing, admission or retirement of a partner, procedures for settling disputes, liquidation etc. Limited life If there is any change in ownership, the partnership must be dissolved and unless the business is closing down, a new partnership is formed. Mutual agency Any partner (unless specifically excluded) can act on behalf of the partnership. So, if a partner enters into a contract or agreement on the business’s behalf and the contract is within the scope of the business’s normal operations, the partnership is bound to the contract. Unlimited liability Every partner is liable for the debts of the partnership to the full extent of his personal worth. This means that if the business falls into debt and one or more partners cannot pay their share, any partner who can pay, must. The exception to this is a sleeping partner who plays no part in the management of the business Co-ownership of property Any assets owned by the partnership business are jointly owned by all the partners. Non-taxable entity In the eyes of the law, a partnership business is not separate from its owners. Therefore the partnership business does not pay tax on its earnings. Instead the profits are divided among the partners according to the profit sharing agreement. Each partner pays personal income tax on his or her own earnings. Partnership accounts Capital account This is the account into which the equity contributed by the partners is entered. If capital is fixed, this account contains only the capital contributed by the partner and does not change If capital is not fixed, this account is altered (increased or decreased) by drawings and share of profits or losses Partnership accounts Drawings account Any drawings of cash, inventory or other partnership assets are debited to this account Current account If capital is fixed, drawings and share of profits or losses will be transferred to this account. Also direct changes in equity brought about by asset revaluations etc. A quick quiz 1. A. A partnership agreement: Has no legal backing Is covered by contract law Is covered by corporations law B. C. 2. A partner has: A. 1 equity account B. C. 2 equity accounts 3 equity accounts If Capital is not fixed If Capital is fixed When Capital is fixed, changes to equity (profit share, drawings etc) are recorded in the Current account. 3. Mutual agency means: A. B. C. Before a decision is made or contract is entered into, all partners must agree An agent must act on the partners’ behalf Any partner can enter into a business contract on behalf of the partnership … provided it is in the normal course of business. If so, the partnership is bound to the contract. 4. Unlimited liability means: A. B. C. All partners are responsible for debts of the business, not just for their share All partners are responsible for their share of business debts Partners are responsible for business debts only up to the value of their equity in the business Partners are liable to the full extent of their personal wealth. If one or more partners cannot pay their share, the other partner/s must. (jointly and severally liable) Objective 2 Account for initial equity invested by the partners Initial Investments As well as cash, partners can contribute other assets to the business. They may also contribute liabilities The net value of each partner’s contribution is credited to his or her Capital account. Note: Assets are recorded at their FAIR or AGREED value. Example: Initial Investment On July 1 2004, Patty Chan and Emma Frost combined their businesses and formed a partnership to sell music players. They named their business Strata Music. Initial Investment Patty contributed: Cash $20,000. Equipment with a book value of $42,000. (Market value $35,000) Stock valued at $15,000 Initial Investment Emma contributed: Cash $60,000. Furniture with a book value of $11,500 and market value of $10,000 Bank loan $20,000 Initial Investment Record Patty’s investment. July 1 2004 Cash 20,000 Equipment 35,000 Inventory 15,000 Patty, Capital Capital contributed by Patty Chan 70,000 Initial Investment Record Emma’s investment. Cash 60,000 Furniture 10,000 Bank Loan 20,000 Emma, Capital 50,000 Capital contributed by Emma Frost Strata Music Balance Sheet as at July 1 2004 Current Assets Non-Current Liabilities Bank Loan 20,000 Cash Inventory 80,000 ______________ 15,000 95,000 Owners’ Equity Patty, Capital 70,000 Non-Current Assets Equipment Furniture 35,000 ______________ 10,000 50,000 45,000 Emma, Capital ______________ 120,000 _________________ ________________ Total assets 140,000 Total liab & equity _________________ ________________ 140,000 Objective 3 Account for changes in equity Changes in equity As with a sole trader business (proprietorship), the equity of the partners is affected by trading profits or losses and by drawings A trading profit will increase equity A trading loss will reduce equity Drawings will reduce equity Accounting for changes in equity Each partner has his/her own Capital account Each partner has his/her own Drawings account If capital is fixed, each partner’s share of profit will be transferred to his/her Current account. Drawings will also be closed to the Current account If capital is not fixed, each partner’s share of profit will be transferred to his/her Capital account. Drawings will also be closed to the Capital account Sharing profits and losses The method by which partners share profits or losses is normally stated in the partnership agreement. If there is no agreement or the agreement does not state how profits and losses are to be shared, partners share profits or losses equally Sharing Profits and Losses The division of profits/losses may take into account unequal contributions of capital and effort. For example: One partner may have contributed a greater value of assets at the commencement of the partnership. One partner may play a more active role in managing the business One partner may have a greater length of service or more experience in the field • • • Capital account or Current account? Three methods of sharing profits/losses are discussed below. Assume for the following examples that the Capital accounts are FIXED This means that the partners’ share of profit is transferred to their Current accounts Stated Fraction this method the profits or losses are shared in set proportions. E.g. 50/50 (equal shares for 2 partners) E.g. 30%, 30%, 40% (unequal shares for 3 partners) E.g. 2:3:3 which is 2/8, 3/8, 3/8 Using Stated Fraction Assume that Patty and Emma have agreed to split profits 60% to Patty and 40% to Emma. What is each partner’s share of $160,000 net profit on June 30 2005? Patty’s share: $160,000 x .6 = $ 96,000 Emma’s share: $160,000 x .4 = $ 64,000 Stated Fraction June 30 2005 Profit and Loss Summary 160,000 Patty, Current 96,000 Emma, Current 64,000 Operating profit allocated to partners If the Capital accounts were not fixed, each partner’s share of the profit would be credited to her Capital account Stated Fraction Using the same formula, record the allocation assuming that the business incurred a $40,000 LOSS for the year Patty’s share: $40,000 x .6 = $24,000 Emma’s share: $40,000 x .4 = $16,000 June 30 Patty, Current Emma, Current P & L Summary 24,000 16,000 40,000 Operating loss allocated to partners Sharing a loss If the Capital accounts were not fixed, each partner’s share of the loss would be debited to her Capital account Sharing profit based on capital contributions This allocates the operating profit or loss according to the amount of capital invested by each partner. Calculate the contribution of each partner to total capital, (proportion), then multiply by the amount to be shared. Capital Contributions Example The partnership earned a profit of $135,000. Profits are to be shared according to the amount of capital contributed. Total capital contributed = $120,000 Calculate proportion contributed by each partner Patty: 70/120 or 7/12 Emma: 50/120 or 5/12 Sharing profit based on capital contributions Then share the profit according to each partner’s proportion of total capital contributed Patty’s share: Emma’s share: 7/12 x $135,000 = 5/12 x $135,000 = $78,750 $56,250 Capital contribution June 30 2005 Profit and Loss Summary 135,000 Patty, Current Emma, Current Operating profit allocated to partners 78,750 56,250 If the Capital accounts were not fixed, each partner’s share of the profit would be credited to her Capital account Combined Formula The profit is shared according to a formula decided on by the partners. This formula could take into account such things as capital contributed, amount of work put in by each partner etc. Combined Formula Assume Patty and Emma share profits and losses on the following terms: Salary to Patty $50,000, to Emma $60,000 Interest of 15% on fixed Capital balances Remainder to be shared equally • • • Profit for the year is $164,000 Sharing profit based on a formula Patty Salary 50,000 Emma 60,000 Interest 15% of capital Remainder 36,000 10,500 18,000 ______________________ _____________________ 7,500 128,000 18,000 __________________ __________________ 78,500 85,500 Sharing profit based on a formula Use the above formula to share a profit of $100,000 Sharing profit based on a formula Patty Salary 50,000 Emma 60,000 Interest 15% of capital Remainder - 28,000 10,500 ______________________ 7,500 128,000 -14,000 -14,000 __________________ _____________________ 46,500 __________________ 53,500 Sharing profit based on a formula June 30 Profit and Loss Summary 100,000 Patty, Current Emma, Current Operating profit allocated to partners 46,500 53,500 A quick quiz … 1. Tim, Ted and Tom share profits/losses in the ratio 1: 2 : 3. This means: A. B. C. Tim’s share is 1/6 Ted’s share is 20% Tom’s share is 3/5 1 : 2 : 3 is 1/6, 2/6, 3/6 So, Tim 1/6 Ted 2/6 and Tom 3/6 2. Mary, Nell and Oliver share profits/losses in the ratio 20%, 30%, 50%. If the partnership profit is $120,000: A. B. C. Mary’s share is $20,000 Nell’s share is $36,000 Oliver’s share is $60,000 Mary’s share = 120,000 x .2 = $24,000 Nell’s share = 120,000 x .3 = $36,000 Oliver’s share = 120,000 x .5 = $60,000 3. Colin, Chris and Carrie share profits based on the following formula: - Salary of $20,000 to Chris and $10,000 to Carrie - Interest to Colin $8,500, to Chris $5,000 and to Carrie $10,000 - Any remainder is shared equally. Prepare a worksheet to share a profit of $130,000 among the partners. 20,000 8,500 76,500 25,500 34,000 5,000 25,500 50,500 10,000 10,000 25,500 45,500 53,500 Partners’ Drawings Drawings by partners reduce equity. They are treated the same way as drawings by a sole proprietor. The Drawings account is debited and the asset taken (cash or something else) is credited. Partners’ Drawings When cash is taken by a partner Drawings XX Cash XX When another asset is taken by a partner Drawings XX Asset XX Partner Drawings At the end of the accounting period the Drawings accounts are closed and the balances are transferred to the partners’ Capital or Current accounts. Dr Capital/Current Cr Drawings XX XX Partners’ Drawings Drawings for the year amounted to $38,000 by Patty and $42,000 by Emma Transfer the partners’ drawings to their Current accounts Partners’ Drawings 30/6/05 Patty, Current Patty, Drawings 38,000 38,000 42,000 42,000 Emma, Current Emma, Drawings Drawings accounts closed Closing the Drawings accounts This also known as Closing drawings to Capital/Current Calculating partnership equity Assuming the profit for the year was $100,000, and it was shared using the combined formula in method 3 above ($46,500 to Patty and $53,500 to Emma), what is the total equity of the partnership on June 30 2005 after the Profit and Loss Summary and Drawings accounts are closed? Reconstruct the Equity section of the partnership balance sheet Patty, Capital Emma, Capital B/F 70,000 B/F 50,000 Patty, Current Drawings Emma, Current Drawings 38,000 Profit 46,500 Bal 8,500 42,000 Profit 53,500 Bal 11,500 _______________________________________________________ _______________________________________________________ Patty, Drawings ________________________________________________________________________________ Emma, Drawings ________________________________________________________________ B/F 38,000 Bal 0 38,000 B/F 42,000 Bal 0 42,000 Balance Sheet (extract) as at June 30 2005 Equity Patty, Capital 70,000 __________________ Patty, Current 8,500 78,500 Emma, Capital Emma, Current Total equity 50,000 __________________ 11,500 61,500 ___________________ 140,000 ================= Review question 1 Answer to Review question 1 A: B: C: 175,000 x 2/7 = 50,000 175,000 x 2/7 = 50,000 175,000 x 3/7 = 75,000 175,000 Profit and Loss Summary A, Current B, Current C, Current 50,000 50,000 75,000 Review question 2 Answer to review question 2 Mary Salary 50,000 Jane 40,000 Interest 10% of capital Remainder 59,580 4,820 29,790 ______________________ _____________________ 5,600 100,420 29,790 __________________ __________________ 84,610 75,390 Answer to review question 2 Profit and Loss Summary Mary, Capital Jane, Capital 160,000 84,610 75,390 Review question 3 Answer to review question 3 (a) Simon, Current Drawings 52,000 Balance b/f Profit 22,200 58,750 __________________________________________________________________________________________________________________________ Balance 28,950 ( b ) Simon’s equity = 50,000 + 28,950 = $78,950 End of Lecture 2
"Introduction to Accounting for Partnerships"