Advanced Accounting Chapter 9

Allocation of Income

Partnership revenues and expenses must be closed out at the end of each fiscal period and the net income allocated to each partner's capital account. A method must be devised for assignment of income. Articles of partnership should stipulate an established procedure. If no arrangement is specified, state partnership laws dictate that all partners receive an equal allocation of income or loss. If the partnership agreement specifies only the division of profits, then losses must be divided in the same manner as directed for profit allocation.

4 Important Capacities For Accounting For Capital Contributions

1)The totals in the individual capital accounts often influence the assignment of profits and losses to the partners 2)The capital account balance is usually one factor in determining the final distribution that will be received by a partner at the time of withdrawal or retirement 3)Ending capital balances indicate the allocation to be made of any assets that remain following the liquidation of a partnership.

Admission of a New Partner- Purchase of a Current Interest

A new partner can purchase partnership interest directly from the existing partners. The cash goes to the partners, not the partnership. Two methods are available to account for the transfer of ownership: Book Value Approach and Goodwill (Revaluation) Approach.

Partnerships

A partnership is defined as "an association of two or more persons to carry on a business as co-owners for profit."

Admission of a New Partner- Contribution to the Partnership Example (Bonus or Goodwill Credited to New Partner

Bonus Method D: Cash 20,000 D: King, Capital (60% of bonus) 2,400 D: Wilson, Capital (40% of bonus) 1,600 C: Goldman, Capital 24,000 To record Goldman's entrance into partnership with reduced payment reported as a bonus from original partners. Goodwill Method D: Cash 20,000 D: Goodwill 5,000 C: Goldman, Capital 25,000 To record Goldman's entrance into partnership with goodwill attributed to this new partner.

Accounting for Capital Contributions 3

Contributed intangible assets require special consideration. Contributions made by one or more of the partners may go beyond assets and liabilities, for example, a particular line of expertise or established clientele. Use either the Bonus Method or Goodwill Method for recording contributed intangible assets.

Withdrawal of a Partner (Hybrid Method)

D: Land 50,000 C: Duncan, Capital (50%) 25,000 C: Smith, Capital (30%) 15,000 C: Windsor, Capital (20%) 10,000 To adjust Land account to fair value as a preliminary step in Windsor's withdrawal. D: Windsor, Capital (to remove account balance) 20,000 D: Duncan, Capital (5/8 of bonus) 3,750 D: Smith, Capital (3/8 of bonus) 2,250 C: Cash 26,000 To record final distribution to Windsor with $6,000 bonus taken from remaining partners.

Partnership Advantages

Flexibility in defining relationships. Profits and losses, and management operating decisions, shared independent of ownership percentages. Ease of formation and dissolution. Taxes "flow-through" to the partners.

Limited Partnership (LP) (Alternative Legal Forms)

Limited partners not allowed to participate in management. Losses are restricted for limited partners to the amount invested. Must have one or more general partners who assume responsibility for all obligations.

Allocation of Income Example

Assume that Tinker, Evers, and Chance form a partnership by investing cash of $120,000,$90,000, and $75,000, respectively. Evers will be allotted 40% of all profits and losses because of previous business experience. Tinker and Chance are to divide the remaining 60% equally. This agreement also stipulates that each partner is allowed to withdraw $10,000 in cash annually from the business. Net income for the period is $60,000. D: Income Summary 60,000 C: Tinker, Capital (30%) 18,000 C Evers, Capital (40%) 24,000 C: Chance, Capital (30%) 18,000 To allocate net income based on provisions of partnership agreement. Statement of Partner's Capital pg. 440.

Alternative Technique-1

Assume the original facts for the Tinkers, Evers, and Chance partnership except an articles of partnership agreement credits each partner annually for interest equal to 10% of that partner's beginning capital balance for the year. Evers and Chance will also be allotted $15,000 each as a compensation allowance in recognition of their participation in daily operations. Any remaining profit or loss will be split 4:3:3, with the largest share gong to Evers because of the work experience that this partner brings to the business. D: Income Summary 60,000 C: Tinker, Capital 12,450 C: Evers, Capital 24,600 C: Chance, Capital 22,950 To allocate income for the year to the individual partners' capital accounts based on partnership agreement. Pg. 441

Accounting for Capital Contributions 2

Green's building is encumbered by a $23,600 mortgage that the partnership has agreed to assume. Green's net investment is equal to $43,400($67,000 less $23,600). The following journal entry records the formation of the partnership created by these contributions. D: Cash 50,000 D: Inventory 10,000 D: Land 11,000 D: Building 46,000 C: Mortgage Payable 23,600 C: Carter, Capital 50,000 C: Green, Capital 43,400 To record properties contributed to start partnership. Assets and liabilities are recorded at fair value.

Accounting for Capital Contributions 1

If one or more of the partners transfers non cash assets, fair value is used to record the assets. Assume that Carter invests $50,000 in cash to begin the previously discussed partnership and Green contributes the following assets. Book Value to Green Calculation: $9,000(inventory)+14,000(land)+32,000(building)=$55,000(Total).Fair Value Calculation: $10,000(inventory)+11,000(land)+46,000(building)=$67,000(Total)

Intangible Contributions Example

James and Joyce open an advertising agency and organize as a partnership. James contributes cash of $70,000 and Joyce invests only $10,000. Joyce, however, is an accomplished graphic artist, a skill that is considered especially valuable to this business. James and Joyce have contributed a total of $80,000 in identifiable assets to their partnership and have decided on equal capital balances.

Subcharter S Corporation (Alternative Legal Forms)

Legal characteristics of a corporation. Ownership limited to 100 stockholders. Owners limited to individuals, estates, and certain tax-exempt entities and trusts (no corporate owners allowed). Profit passes to owners as a partnership.

Admission of a New Partner- Contribution to the Partnership Example

An outsider may be admitted to a partnership by contributing directly to the business. Assume King and Wilson maintain a partnership and presently report capital balances of $80,000 and $20,000, respectively. According to the articles of partnership, King is entitled to 60% of all profits and losses with the remaining 40% credited each year to Wilson. Goldman can enter the partnership for $20,000 cash with the money going into the business. Goldman receives an initial 10% interest in partnership property. Bonus Credited to Original Partners D: Cash 20,000 C: Goldman, Capital (10% of total capital) 12,000 C: King, Capital (60% of bonus) 4,800 C: Wilson, Capital (40% of bonus) 3,200 To record Goldman's entrance into partnership with $8,000 extra payment recorded as a bonus to the original partners. Goodwill Credited to Original Partners D: Goodwill (or specific accounts) 80,000 C: King, Capital (60% of goodwill) 48,000 C: Wilson, Capital (40%) 32,000 To recognize goodwill based on Goldman's purchase price. D: Cash 20,000 C: Goldman, Capital 20,000. To record Goldman's admission into partnership. Hybrid Method D: Land 30,000 C: King, Capital (60% of revaluation) 18,000 C: Wilson, Capital (40%) 12,000 To record current fair value of land in preparation for admission of new partner. D: Cash 20,000 C: Goldman, Capital (10% of total capital) 15,000 C: King, Capital (60% of bonus) 3,000 C: Wilson, Capital (40% of bonus) 2,000 To record entrance of Goldman into partnership and bonus assigned to original partners.

Legal Dissolution

Any alteration in the specific individuals composing a partnership results in "legal dissolution". Examples: departures, retirement, death, admission (including promotion) of a New Partner, Immediate formation of a new partnership as business continues, New partner acquires partnership interest by: Purchasing it from the other partners, or making a contribution to the partnership, can lead to termination and liquidation.

Allocation of Income 1

The allocation of income is not necessarily based on the relative capital balances. It is a separately negotiated item. Items to be allocated: Interest on beginning capital balances- allocated compensation- bonuses- remaining income.

Alternative Techniques-2

The assignment process is merely a series of mechanical steps reflecting the change in each partner's capital balance resulting from the provisions of the partnership agreement. The number of different allocation procedures that could be employed is limited solely by the partner's imagination. Although interest, compensation allowances, and various ratios are the predominant factors encountered in practice, numerous other possibilities exist.

Admission of a New Partner- The Rights of a Partner

An individual partner's ownership rights include: the right to co-ownership in the business property, the right to share in profits and losses as specified in the partnership agreement, the right to participate in the management of the business. The first two rights can be sold (unless restricted by the articles of partnership). The last right cannot be sold without the other partners' approval.

Admission of a New Partner- Purchase of a Current Interest Example

Assume Scott, Thompson, and York formed a partnership, and subsequently, York decides to leave the partnership. He offers to sell his interest to Morgan. Although York may transfer the right of property ownership as well as the specified share of future profits and losses, the partnership does not automatically admit Morgan. York legally remains a partner until such time as both Scott and Thompson agree to allow Morgan to participate in the management of the business. Book Value Approach Instead of York selling his interest to Morgan, each of these three partners elects to transfer a 20 percent interest to Morgan for a total payment of $30,000 in a simple capital reclassification. The money is paid directly to the owners. D: Scott, Capital (20% of capital balance) 10,000 D: Thompson, Capital (20%) 6,000 D: York, Capital (20%) 4,000 C: Morgan, Capital (20% of total) 20,000. To reclassify capital to reflect Morgan's acquisition. Money is paid directly to partners. Goodwill Approach Scott, Thompson, and York is transferring all assets and liabilities to the partnership of Scott, Thompson, York, and Morgan. The goodwill method recognizes the transaction as occurring between two separate reporting entities that necessitates the complete revaluation of all assets and liabilities. Because Morgan is paying $30,000 for a 20% interest in the partnership, implied value of the business as a whole is $150,000 (30,000/20%). However, the book value is only $100,000; thus, a $50,000 upward revaluation is indicated. This adjustment is reflected by restating specific partnership asset and liability accounts to fair value with any remaining balance recorded as goodwill. D: Goodwill (or specific accounts) 50,000 C: Scott, Capital (20% of goodwill) 10,000 C: Thompson, Capital (50%) 25,000 C: York, Capital (30%) 15,000 To recognize goodwill and revaluation of assets and liabilities based on value of business implied by Morgan's purchase price. D: Scott, Capital (20% x new $60,000 capital balance) 12,000 D: Thompson, Capital (20% x $55,000) 11,000 D: York, Capital (20% x $35,000) 7,000 C: Morgan, Capital (20% x $150,000 new total) 30,000 To reclassify capital to reflect Morgan's acquisition. Money is paid directly to partners.

Accounting for Capital Contributions

Assume that Carter and Green form a business to be operated as a partnership. Carter contributes $50,000 in cash and Green invests $20,000. The initial journal entry to record the creation of a partnership: D: Cash 70,000 C: Carter, Capital 50,000 C: Green, Capital 20,000 To record cash contributed to start new partnership.

Limited Liability Partnership (LLP) (Alternative Legal Forms)

Owners: risk their own investments, are responsible for contractual debts of the business, are liable only for their own acts and omissions, and those of individuals they directly supervise.

Articles of Partnership

The Uniform Partnership Act established standards and rules for partnerships but a written agreement will supersede the UPA standards. Articles of partnership should always clearly describe the: Name and address of each partner, business location, nature of the business, rights and responsibilities of each partner, initial contribution to be made by each partner and the method to be used for valuation, Specific method by which profits and losses are to be allocated, periodic withdrawal of assets by each partner, procedure for admitting new partners, method for arbitrating partnership disputes, life insurance provisions enabling remaining partners to acquire the interest of any deceased partner, method for settling a partner's share in the business upon withdrawal, retirement, or death.

Withdrawal of a Partner

The Withdrawing Partner is paid out in accordance with the Partnership Agreement. Using the Bonus Method, any amount paid in excess of that partner's capital account is allocated against the remaining partners' capital accounts. Using the Goodwill Method, the books are first adjusted to FMV, with a proportion of the increase allocated to each partner's account. The withdrawing partner is then paid based on the balance in the individual capital account. Example: Assume that the partnership of Duncan, Smith, and Windsor has existed for a number of years. Windsor decides to withdraw from the partnership, but Duncan and Smith plan to continue operating the business. As per the original partnership agreement, a final settlement distribution for any withdrawing partner is computed based on the following specified provisions: 1. An independent expert to appraise the business to determine its estimated fair value 2. Any individual who leaves the partnership will receive cash or other assets equal to that partner's current capital balance after including an appropriate share of any adjustment indicated by the previous valuation. The allocation of unrecorded gains and losses is based on the normal profit and loss ratio. Following Windsor's decision to withdraw from the partnership, its property is immediately appraised. Total fair value is estimated at $180,000, a figure $80,000 in excess of book value. According to this valuation, land held by the partnership is currently worth $50,000 more than its original cost. In addition, $30,000 in goodwill is attributed to the partnership based on its value as a going concern. Therefore, Windsor receives $26,000 on leaving the partnership: the original $10,000 capital balance plus a 20% share of this $80,000 amount. The amount of payment is not in dispute, but the method of recording the withdrawal is. Bonus Method Applied D: Windsor, Capital (to remove account balance) 10,000 D: Duncan, Capital (5/8 of excess contribution) 10,000 D: Smith, Capital (3/8 of excess contribution) 6,000 C: Cash 26,000 To record Windsor's withdrawal with $16,000 excess distribution taken from remaining partners. Goodwill Method Applied D: Land 50,000 D: Goodwill 30,000 C: Duncan, Capital (50%) 40,000 C: Smith, Capital (30%) 24,000 C: Windsor, Capital (20%) 16,000 To recognize land value and goodwill as a preliminary step to Windsor's withdrawal. D: Windsor, Capital (to remove account balance) 26,000 C: Cash 26,000 To distribute cash to Windsor in settlement of partnership interest.

Intangible Contributions- Bonus Method Example

The bonus method simply splits the $80,000 capital evenly between the two partners. Joyce received a capital bonus of $30,000 (the $40,000 recorded capital balance in excess of the $10,000 cash contribution) from James in recognition of her artistic abilities she contributed. D: Cash 80,000 C: James, Capital 40,000 C: Joyce, Capital 40,000 To record cash contributions with bonus to Joyce because of artistic abilities. This approach only recognizes the assets that are physically transferred to the business.

Capital Accounts (Partnerships)

The equity section of a partnership consists of capital balances for each partner. Profits/losses for each period are allocated to each partner's capital account. Withdrawals by partners reduce their capital accounts.

Intangible Contributions- Goodwill Method Example

The goodwill method is based on the assumption that an implied value can be calculated mathematically and recorded for any intangible contribution made by a partner. Ex: Joyce invested $10,000 cash, $60,000 less than James, but receives an equal amount of capital according to the partnership agreement. Joyce's artistic talent has an apparent value of $60,000, a figure that should be included as part of this partner's capital investment. If not recorded, Joyce's primary contribution to the business is ignored completely within the accounting records. D: Cash 80,000 D: Goodwill 60,000 C: James, Capital 70,000 C: Joyce, Capital 70,000 To record cash contributions with goodwill attributed to Joyce in recognition of artistic abilities.

Admission of a New Partner- Contribution to the Partnership

The new partner can also gain partnership interest by contributing cash to the partnership. Remember that the new cash will increase the partnership's net assets. Two methods are: Bonus Approach, Goodwill Approach.

Partnership Disadvantages

Unlimited liability incurred by each partner (they are "jointly and severally" liable). Mutual agency (each partner has right to incur liabilities in the name of the partnership). Inability to participate in various corporate tax benefits.

Limited Liability Company (LLC) (Alternative Legal Forms)

new type of organization in US. They have long been based in Europe and other areas. They are classified as partnerships for tax purposes. In contrast to Sub Chapter S Corporations, the number of owners is not usually restricted. Owners only risk their own investments.