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Chapter 2

Chapter 2. Accounting for Partnerships: Organization and Operation. Objectives of the Chapter. To learn the accounting and reporting for limited liability partnerships (LLPs) including:

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Chapter 2

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  1. Chapter 2 Accounting for Partnerships: Organization and Operation

  2. Objectives of the Chapter • To learn the accounting and reporting for limited liability partnerships (LLPs) including: • a. the organization, b. the income-sharing plans, c. the financial statements, and d. the changes in ownership. • To learn the accounting for limited partnerships Partnerships: Organization and Operation

  3. Partnerships • The Uniform Partnership Act defines a partnership as: "an association of two or more persons to carry on, as co-owners, a business for profit". • Partnerships generally are associated with the practice of law, medicine, public accounting and other professions, and also with small business enterprises. Partnerships: Organization and Operation

  4. Partnerships (contd.) • General partnership: in which all partners have unlimited personal liability for debts of the partnership. • Limited liability partnerships (LLPs): individual partners of LLPs are personally responsible for their own actions and for the actions of employees under their supervision. Partnerships: Organization and Operation

  5. Partnerships (contd.) • The LLPs as a whole, like a general partnership, is responsible for the actions of all partners and employees. • Since the LLPs are the prevalent form of partnerships and the issues of organization, income-sharing plans and changes in ownership of LLPs are similar to those of general partnerships, LLPs are discussed in this chapter. Partnerships: Organization and Operation

  6. Organization of a Limited Liability Partnership (LLP) • Basic Characteristics of the LLP: • Ease of Formation. • Limited Life. • Mutual Agency. • Co-Ownership of Partnership Assets and Earnings. Partnerships: Organization and Operation

  7. Major Differences between an LLP and a Corporation • Characteristics of a corporation: • 1. Separated legal entity from its owners: it can buy, sell and own properties. • 2. Limited liability for stockholders. • 3. Continuous existence. • 4. Ease of transfer of ownership. • 5. Ease of capital generation. Partnerships: Organization and Operation

  8. Major Differences between an LLP and a Corporation (contd.) • 6. Centralized authority and responsibility-- to the President, not to numerous owners. • 7. Professional management • 8. Corporation taxes (double taxation). • 9. Separation of ownership and management: principal & agent conflicts. • 10. Government regulations. Partnerships: Organization and Operation

  9. Taxation of LLP • An LLP pays no income tax. • LLP is only required to file an annual information return showing its revenue and expenses, the amount of its net income and the division of the net income among the partners. Partnerships: Organization and Operation

  10. Taxation of LLP • The partners of LLP report their shares of the ordinary net income from the partnership and dividends and charitable contributions in their individual income tax returns, regardless of whether they received more of less than this amount of cash from the LLP. Partnerships: Organization and Operation

  11. Is the LLP a Separate Entity ? • Legal status: a partnership is an "association of persons" and is not a separate entity while a corporation is a separate entity from its owners. • Economic substance: in terms of managerial policy and business objectives, LLPs are as much business and accounting entities as are corporations. Partnerships: Organization and Operation

  12. Is the LLP a Separate Entity ? (contd). • LLPs typically are guided by long-range plans not likely to be affected by the admission or departure of a single partner. • The accounting policies of LLPs should reflect the fact that the partnership is an accounting entity apart from its owners. Partnerships: Organization and Operation

  13. The Partnership Contract • A good business practice requires the partnership contract in writing. • The followings are a few important points to be covered in a written contract for a LLP: Partnerships: Organization and Operation

  14. The Partnership Contract (contd.) • The formation date and the planned duration of the partnership; the names of the partners, and the name and business activities of the partnership. • The assets to be invested by each partner, the procedure for valuing noncash investments, and the penalties for a partner's failure to invest and maintain the agreed amount of capital. Partnerships: Organization and Operation

  15. The Partnership Contract (contd.) • The authority, the rights and the duties of each partner. • The accounting period to be used, the nature of accounting records, financial statements and audits by independent public accountants. • The net income (loss) sharing plans. Partnerships: Organization and Operation

  16. The Partnership Contract (contd.) • The drawings allowed to each partner. • Insurance on the lives of partners • Provision for arbitration of disputes. • Provision for liquidation of the partnership at the end of the term specified in the contract or at the death or retirement of a partner. Partnerships: Organization and Operation

  17. Ledger Accounts for Partners • The following three types of accounts are used in LLPs for each partner: • Capital accounts. • Drawing accounts. • Accounts for loans to and from partners. Partnerships: Organization and Operation

  18. Ledger Accounts for Partners (contd.) • The original investment from partner is recorded as: Assets (based on current fair value) $$$ Liabilities $$$ Capital-Partner A $$$ • Drawings from Partners are recorded as: Drawing –Partner A $$$ Cash $$$ Partnerships: Organization and Operation

  19. Ledger Accounts for Partners (contd.) • At the end of each accounting period, the income summary ledger account is transferred to the capital accounts in accordance with income sharing plan specified in the contract. • Also, the debit balances in the drawing accounts are closed to the partner's capital account. Partnerships: Organization and Operation

  20. Ledger Accounts for Partners (contd.) • Loans Receivable from Partners: this account is debited when a partner receives cash from the LLP with the intention to repay this amount. • Loans Payable to Partners: this account is credited when a partner makes a cash payment to the LLP that is considered a loan rather than an investment. Partnerships: Organization and Operation

  21. Ledger Accounts for Partners (contd.) • If a substantial unsecured loan has been made to a partner and repayment appears doubtful, it is appropriate to offset the receivable against the partner's capital account. Partnerships: Organization and Operation

  22. Valuation of Investments by Partners • Gains or losses from disposal of noncash assets invested by the partners is measured as: • The disposal price – the current fair value of the assets when invested adjusted for any depreciation or amortization to the date of disposal. • These gains (losses) are divided based on the income sharing plan of the LLP. Partnerships: Organization and Operation

  23. Income-Sharing Plans for LLP • Partners can agree on any type of income sharing plan regardless of the amount of their respective capital investment. • The Uniform Partnership Act states that if partners fail to specify a plan for sharing net income/loss, it is assumed that they intend to share equally. Partnerships: Organization and Operation

  24. Income-Sharing Plans for LLP (contd.) • The following are a few possible plans of income-sharing: • Equally. • In the ratio of partners' capital account balance on a specific date or in the ratio of average capital account balance in the year. • Allowing interest on partner's capital account balances and dividing the remaining net income/loss in a specified ratio. Partnerships: Organization and Operation

  25. Income-Sharing Plans for LLP (contd.) • Allowing salaries to partners and dividing the remaining net income/loss in a specified ratio. • Bonus to managing partner based on income. • Allowing salaries to partners, allowing interest on capital account balances, and dividing the remaining net income/loss in a specified ratio. Partnerships: Organization and Operation

  26. Income-Sharing Plans for LLP-Examples • Alb & Bay LLP had a net income of $300,000 for the year ended 12/31/99, the first year of operation. • The partnership contract provides that each partner may withdraw $5,000 cash on the last day of each month. Both partners did so during 1999. • All other withdrawals, investments and net income/loss are entered directly in the capital account. Partnerships: Organization and Operation

  27. Income-Sharing Plans for LLP-Examples (contd.) • Alb invested $4,000,000 on 1/1/99 and an additional $100,000 on 4/1. Bay invested $800,000 on 1/1/ and withdrew $50,000 on 7/1. • These transactions and events are summarized in the following ledger accounts: Partnerships: Organization and Operation

  28. Income-Sharing Plans for LLP-Examples (contd.) Alb, Capital Bay, Capital 400,000…1/1 7/1..50,000 800,000..1/1 100,000…4/1 Alb, Drawing Bay, Drawing Jan.-Dec.60,000 Jan.-Dec. 60,000 Income Summary 300,000…12/31 Partnerships: Organization and Operation

  29. Income-Sharing Plans for LLP-Examples (contd.) • If the entire net income is shared equally, the following entry is recorded: Income Summary 300,000 Alb, Capital 150,000 Bay, Capital 150,000 At the end of 1999, the drawing accounts are to be closed to Income Summary as follows: Alb, Capital 60,000 Bay, Capital 60,000 Alb,Drawing 60,000 Bay,Drawing 60,000 Partnerships: Organization and Operation

  30. Income-Sharing Plans for LLP-Examples (contd.) • The entire income/loss can be shared at any specified ratio specified in the contract. • LLP can apply one sharing ration to net income but another ratio to net loss. • LLP can apply one sharing ratio to net income equal or less than a specific amount but another ratio to net income greater than that amount. Partnerships: Organization and Operation

  31. Income-Sharing Plans for LLP-Examples (contd.) • The entire income/loss of LLP can also be shared by the ratio of partners' capital account balances such as: • by the original capital investments, • by the capital account balance at the, beginning of each year, • by the balances at the end of each year (before the distribution of net income/loss), and • by the average balances during the year. Partnerships: Organization and Operation

  32. Income-Sharing Plans for LLP-Examples (contd.) • The assumption of the sharing based on the capital ratio is that the capital investment is the sole determinant of the income of LLP. • Thus, another common practice in income sharing of LLP is to divide only a portion of net income in the capital ratio and to divide the remainder equally or in some other specified ratio. Partnerships: Organization and Operation

  33. Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio • A method to carry out the above sharing scheme is to allow interest on partners' capital balance at 15%, for example, and dividing the remainder at a specified ratio. • This method is the same as dividing only a portion of net income in the ratio of partners' capital balances. • If this income sharing scheme is used, LLP needs to specify the interest rate and the capital account balances to be used. Partnerships: Organization and Operation

  34. Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio • Example: Assume that the partnership contract allows interest on partners' average capital account balances at 15% with remainder to be divided equally. • The net income of $300,000 for 1999 is divided as follows: • Note: the average capital balances for Alb and Bay are $475,000 and $775,000, respectively. Partnerships: Organization and Operation

  35. Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (contd.) Partnerships: Organization and Operation

  36. Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (condt.) • The provision of allowing interest on capital balance should be carried out even in the case of net loss unless otherwise indicated in the contract. • Example (with net loss): assume that $10,000 net loss incurred for the year of 1999, the following table presents the division of the net loss for the year of 1999: Partnerships: Organization and Operation

  37. Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (condt.) Partnerships: Organization and Operation

  38. Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (condt.) The journal entry to close the Income Summary ledger account on December 31, 1999, is shown below: Alb, Capital 27,500 Income Summary 10,000 Bay, Capital 17,500 To record division of net loss for 1999. Partnerships: Organization and Operation

  39. Interest on Partner's Capital account balances with Remaining Divided in Specified Ratio (condt.) • The rational underlies the above allocation: • The above income sharing scheme assumes that capital is NOT the only factor to cause the net loss; therefore, the net loss should not be allocated solely on the capital ratio. Partnerships: Organization and Operation

  40. Salary Allowance with Remaining Net Income Divided in Specific ratio • One partner may contribute more services to the LLP than the other. • If the income-sharing is based solely on the amount of services provided by each partner, the following problems arise: • 1) the success of a LLP is not determined solely by the services provided by partners. • 2) in the case of net loss, the partner renders more services will absorb a larger portion of the loss. Partnerships: Organization and Operation

  41. Salary Allowance with Remaining Net Income Divided in Specific ratio (contd.) • One solution to avoid these problems as well as recognize the unequal services of partners is to provide salaries to partners based on their services to the LLP. • The remaining net income is to be shared equally or in a specified ratio. • Example: assume the contract provides for an annual salary of $100,000 to Alb and $60,000 to Bay with remaining net income divided equally. Partnerships: Organization and Operation

  42. Salary Allowance with Remaining Net Income Divided in Specific ratio (contd.) • The salaries are paid monthly during the year. The net income of $140,000 ($300,000-100,000-60,000) for 1999 is divided as follows: Partnerships: Organization and Operation

  43. Salary Allowance with Remaining Net Income Divided in Specific ratio (contd.) • Monthly Journal Entries: • Salaries Expense 13,333 Capital –Alb 8,333 Capital-Bay 5,000 • Alb, Drawing 8,333 Bay, Drawing 5,000 Cash 13,333 • Income Summary 140,000 Alb, Capital 70,000 Bay, Capital 70,000 Partnerships: Organization and Operation

  44. Bonus to Managing Partner Based on Income • A partnership contract may provide bonus to the managing partners equal to a specified % of income. • The contract should state whether the % is based on the income prior to the bonus or after the bonus. • Example (% is based on the income after the bonus): Partnerships: Organization and Operation

  45. Bonus to Managing Partner Based on Income (contd.) • Assume that the net income is $300,000 and the contract provided for a bonus of 25% of income after the bonus to Partner Alb. The remainder of net income is to be divided equally. The bonus to Alb is computed as follows: • 0.25 x ($300,000-B) = B => $75,000 = 1.25 x B => B = $60,000 • Note: The concept of a bonus is not applicable to a net loss. Partnerships: Organization and Operation

  46. Salaries to Partners with Interest on Capital Accounts • Many LLPs divide income or loss by allowing salaries to partners and also interest on their capital account balances. • Any resultant net income or loss is divided equally or in some other ratio. • Example: assume the following: • Annual salaries of $100,000 to Alb and $60,000 to Bay, recognized as operating expense. Partnerships: Organization and Operation

  47. Salaries to Partners with Interest on Capital Accounts (contd.) • Interest on average capital account balances, as computed on page 39 ($71,250 for Alb and $116,250 for Bay). • The remaining net income or loss divided equally. • Assuming income of $300,000 fir 1999 before annual salaries, the $140,000 net income is divided as follows: Partnerships: Organization and Operation

  48. Salaries to Partners with Interest on Capital Accounts –Example (contd.) Partnerships: Organization and Operation

  49. Financial Statements of an LLP – Income Statement Partnerships: Organization and Operation

  50. Financial Statements of an LLP – Income Statement (contd.) • Notes to the I/S: • Explanations of the division of net income may be included in the partnership's income statement or in a note to the financial statements. • A partnership in not subject to income taxes. Partnerships: Organization and Operation

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