Accounting: The Language of Business (Part 82)

We have a remarkably complete picture in many ways - and it could be that we're not accounting for something that's almost three-quarters of the entire universe.

Saul Perlmutter

 Accounting for Partnerships and Limited Liability Corporations (Part C)

by

Charles Lamson

Forming a Partnership

In forming a partnership, the investments of each partner are recorded in separate entries. The assets contributed by a partner are debited to the partnership asset accounts. If liabilities are assumed by the partnership, the partnership liability accounts are credited. The partner's capital account is credited for the net amount.

To illustrate, assume that Joseph Stevens and Earl Foster, owners of competing hardware stores, agreed to combine their businesses in a partnership. Each is to contribute certain amounts of cash and other assets. Stevens and Foster also agree that the partnership is to assume the liabilities of the separate businesses. The entry to record the assets contributed and the liabilities transferred by Stevens is as follows:

A similar entry would record the assets contributed and the liabilities transferred by Foster. In each entry, the noncash assets are recorded at values agreed upon by the partners. These values normally represent current market values and thus usually differ from the book values of the assets in the records of the separate businesses. For example, the store equipment recorded at $5,400 in the preceding entry may have had a book value of $3,500 in Stevens' ledger (cost of $10,000 less accumulated depreciation of $6,500). As a further example, receivables contributed to the partnership are recorded at their face amount. Only accounts that are likely to be collected are normally transferred to the partnership.

Dividing Income

Many partnerships have been dissolved because partners could not agree on how to distribute income equitably. Therefore, the method of dividing partnership income should be stated in the partnership agreement. In the absence of any agreement or if the agreement is silent on dividing net income or net losses, all partners share equally. However, if one partner contributes a larger portion of capital than the others, then net income should be divided to reflect the unequal capital contributions. Likewise, if the services rendered by one partner are more important than those of the others, net income should be divided to reflect the unequal service contributions. In the following paragraphs, partnership agreements that recognize these differences are illustrated.

Dividing Income---Services of Partners

One method of recognizing differences in partners' abilities and in amount of time devoted to the business provides for salary allowances to partners. Since partners are legally not employees of the partnership, such allowances are treated as divisions of the net income and are credited to the partners' capital accounts.

To illustrate, assume that the partnership agreement of Jennifer Stone and Crystal Mills provides for monthly salary allowances. Stone is to receive a monthly allowance of $2,500 ($30,000 annually), and Mills is to receive $2,000 a month ($24,000 annually). Any net income remaining after the salary of allowances is to be divided equally. Assume also that the net income for the year is $75,000.

A report of the division of net income may be presented as a separate statement to accompany the balance sheet and the income statement or disclosed within the statement of partnership capital. Another format is to add the division to the bottom of the income statement. If the latter format is used, the lower part of the income statement would appear as follows:

The net income division is recorded as a closing entry, even if the partners do not actually withdraw the amounts of their salary allowances. The entry for dividing net income is as follows:

If Stone and Mills had withdrawn their salary allowances monthly, the withdrawals would have been debited to their drawing accounts during the year. At the end of the year, the debit balances of $30,000 and $24,000 in their drawing accounts would be transferred as reductions to their capital accounts.

Accountants should be careful to distinguish between salary allowances and partner withdrawals. The amount of net income distributed to each partner's capital account at the end of the year may differ from the amount the partner withdraws during the year. In some cases, the partnership agreement may limit the amount of withdrawals a partner may make during a period.

Dividing Income---Services of Partners and Investments

Partners may agree that the most equitable plan of dividing income is to provide for (1) salary allowances and (2) interest on capital investments. Any remaining net income is then divided as agreed upon. For example, assume that the partnership agreement for stone and Mills divides income as follows:

1. Monthly salary allowances of $2,500 for Stone and $2,000 for Mills.

2. Interest of 12% on each partner's capital balance on January 1.

3. Any remaining net income divided equally between the partners.

Stone had a credit balance of $80,000 in her capital account on January 1 of the current fiscal year, and Mills had a credit balance of $60,000 in her capital account. The $75,000 net income for the year is divided per the following schedule:

For the above example, the entry to close the income summary account is shown below.

Dividing Income---Allowances Exceed Net Income

In the preceding example, the net income exceeded the total of the salary and interest allowances. If the net income is less than the total of the allowances, the remaining balance will be a negative amount. And this amount must be divided among the partners as though it were a net loss.

To illustrate, assume the same salary and interest allowances as in the preceding example but that the net income is $50,000. The salary and interest allowances total $39,600 for Stone and $31,200 for Mills. The sum of these amounts, $70,800, exceeds the net income of $50,000 by $20,800. This $20,800 excess must be divided between Stone and Mills. Under the partnership agreement, any net income or net loss remaining after deducting the allowances is divided equally between Stone and Mills. Thus, each partner is allocated one half of the $20,800, and $10,400 is deducted from each partner's share of the allowances. The final division of net income between Stone and Mills is shown below.

In closing Income Summary at the end of the year, $29,200 would be credited to Jennifer Stone, Capital, and $20,800 would be credited to Crystal Mills, Capital. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 525-527*

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Accounting: The Language of Business (Part 81)

While it's trendy to outsource your accounting to a third party, once you hit a certain size, it's dangerous.

Brad Feld

 Accounting for Partnerships and Limited Liability Corporations (Part B)

by

Charles Lamson

Equity Reporting for Alternate Entity Forms

The owners of any business are concerned with their proportional ownership and changes in their ownership. This is because the owners' proportional ownership often determines their share of earnings and the value of their ownership interest. As a result, a business reports the ownership equity balances and changes in those balances. In the following sections, such equity reports are Illustrated for each entity form.

Equity Reporting for Proprietorships

Since the proprietorship is a separate entity for accounting purposes. The transactions of the proprietorship must be kept separate from the personal financial affairs of the owner. Only in this way can the financial condition and the results of operations of the proprietorship be accurately measured and reported.

The accounting for a proprietorship was illustrated in an earlier post. This accounting includes the use of a capital account to record investments by the owner in the business. At the end of the period, the net income or net loss is closed to the owner's capital account by using Income Summary. Withdrawals by the owners are recorded in the owner's drawing account. At the end of the period, the drawing account is closed to the owner's capital account, and a statement of owner's equity is prepared.

The statement of owner's equity summarizes changes in owner's capital for a period of time. To illustrate, the statement of owner's equity for a proprietorship, Greene Landscapes, owned by Duncan Greene, is shown below.

Equity Reporting for Corporations

The accounting for a corporation was illustrated in preceding posts. This accounting includes the use of capital stock accounts, such as Common Stock and Preferred Stock, to record investments by the stockholders. Through the closing process (The closing process is a step in the accounting cycle that occurs at the end of the accounting period, after the financial statements are completed. This serves to get everything ready for the next year.), dividends and the net income or net loss are recorded in the retained earnings account.

Significant changes in stockholders' equity should be reported for the period in which they occur. When the only change in stockholders' equity is due to net income or net loss and dividends, a retained earnings statement such as the one illustrated in part 79 is sufficient. However, when a corporation also has changes in stock and other paid-in capital accounts, a statement of stockholders' equity is normally prepared. The statement is often prepared in a columnar format where each column represents a major stockholders' equity classification. Changes in each classification are then described in the left hand column. Exhibit 2 illustrates a statement of stockholders' equity for Telex Inc.

EXHIBIT 2 Statement of Stockholders' Equity

Equity Reporting for Partnerships and Limited Liability Corporations

Reporting changes in partnership capital accounts is similar to that for a proprietorship except that there is no owner's capital account for each partner. The change in the owners' capital accounts for a period of time is reported in a statement of partnership equity. The statement of partnership equity discloses each partner's capital account in the columns and the reasons for the change in capital in the row. Exhibit 3 illustrates the disclosure for Investors Associates, a partnership of Dan Cross and Kelly Baker.

EXHIBIT 3 Statement of Partnership Equity

The equity reporting for an LLC is similar to that of a partnership. Instead of a statement of partnership capital, a statement of members' equity is prepared. The statement of members' equity discloses the changes in member equity for a period. The disclosure would be very similar to Exhibit 3, except that the columns would be the members of the LLC rather than partners. The statement of members' equity for HealthNet, LLC, is illustrated in Exhibit 4.

EXHIBIT 4 Statement of Members' Equity

Accounting for Partnerships and Limited Liability Corporations

Most of the day-to-day accounting for partnership or an LLC is the same as the accounting for any other forms of business organization. The accounting system described in previous posts may, with minimal changes, be used by a partnership or an LLC. However, the formation, division of net income or net loss, dissolution, and liquidation of partnerships and LLCs give rise to unique transactions.

In the next several posts, we will discuss and illustrate these unique transactions for a partnership and an LLC. Since an LLC is treated in the same manner as a partnership, except that the terms "member" and "members equity" are used rather than "partner" or "owners' capital," we show the parallel journal entries for an LLC alongside the partnership entries. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 521-524*

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14. Vijayanagara - The Last Emperors of South India

Accounting: The Language of Business (Part 80)

With greater extensibility and programmability, bitcoin can evolve to enable transformations in how all forms of property are secured and exchanged, how voting and governance function, including spilling into the automation of commercial law, audit, and accounting.

Jeremy Allaire

Accounting for Partnerships and Limited Liability Corporations (Part A)

by

Charles Lamson

If you were to start up any type of business, you would want to separate the business affairs from your personal affairs. Keeping business transactions separate from personal transactions aids business analysis and simplifies tax reporting. For example, if you provided freelance photography services, you would want to keep a business checking account for depositing receipts for services rendered and writing checks for expenses. At the end of the year, you would have a basis for determining the earnings from your business and the information necessary for completing your tax return. In this case, forming the business would be as simple as establishing a name and a separate checking account. As a business becomes more complex, the form of the business entity becomes an important consideration. The entity form has an impact on the owner's legal liability, taxation, and the ability to raise capital. The four major forms of business entities that we will discuss in the next several posts are the proprietorship, corporation, partnership, and limited liability corporation. 

Alternate Forms of Business Entities

A variety of legal forms exist for forming and operating a business. The four more common legal forms are proprietorships, corporations, partnerships, and limited liability corporations. In this post, we describe the characteristics of each of these business entities.

Proprietorships

As we discussed in part 1, a proprietorship is a business enterprise owned by a single individual. Internal Revenue Service (IRS) data indicate that proprietorships comprise more than 73% of the business tax returns filed but only 7.7% of all business revenues (bigideasforsmallbusiness.com). This statistic suggests that proprietorships, although numerous, consist mostly of small businesses. The most common type of proprietorships are professional service providers, such as lawyers, architects, realtors, and physicians.

A proprietorship is simple to form. Indeed, you may already be a proprietor. For example, a person providing childcare services for friends of the family is a proprietor. There are no legal restrictions or forms to file in forming a proprietorship. The ease of forming a proprietorship is one of its main advantages. In addition, the individual owner can usually make business decisions without consulting others. This ability to be one's own boss is a major reason why many individuals organize their businesses as proprietorships.

A proprietorship is a separate entity for accounting purposes, and when the owner dies or retires, the proprietorship ceases to exist. For federal income tax purposes, however, the proprietorship is not treated as a separate taxable entity. The income or loss is said to "pass through" to the owner's individual income tax return. Thus, the income from a proprietorship is taxed only at the individual level.

A primary disadvantage of a proprietorship is the difficulty in raising large amounts of capital. Investment in the business is limited to the amount that the owner can provide from personal resources, plus any additional amounts that can be raised through borrowing. In addition, the owner is personally liable for any debts or legal claims against the business. In other words, if the business fails, creditors have rights to the personal assets of the owner, regardless of the amount of the owner's actual investment in the enterprise.

Corporations

The major benefits of the corporate form are its ability to provide limited liability to its owners and its potential for raising large amounts of capital through issuing stock. For these reasons, most large businesses use the corporate form of entity.

However, corporations also have disadvantages. Forming a corporation requires legal filings to and approvals by state regulatory agencies. In addition, corporations are more complex to manage and must be operated in accordance with the corporate bylaws. Corporations are taxed as a separate entity. Thus, when earnings are distributed to shareholders in the form of dividends, they are also taxed again at the individual level.

To avoid the double taxation of dividends a business may organize an S corporation. Under an S corporation, the IRS allows income to pass through the corporation to the individual stockholders without the corporation having to pay taxes on the income. However, the S corporation has a number of legal imitations, including a limitation on the number of stockholders. In recent years, the S corporation has become less popular due to the emergence of the limited liability corporation and its many advantages, which we will discuss later in this post.

 

Partnerships

A partnership is an association of two or more persons who own and manage a business for profit. Partnerships have several characteristics with accounting implications.

A partnership has a limited life. A partnership dissolves whenever a partner ceases to be a member of the firm. For example, a partnership is dissolved if a partner withdraws due to bankruptcy, incapacity, or death. Likewise, admitting a new partner dissolves the old partnership. When a partnership is dissolved, the remaining partners must form a new partnership if operations of the business are to continue.

In most partnerships, the partners have unlimited liability. That is, each partner is individually liable to creditors for debts incurred by the partnership. Thus, if a partnership becomes insolvent, the partners must contribute sufficient personal assets to settle the debts of the partnership.

Partners have co-ownership of partnership property. The property invested in a partnership by a partner becomes the joint property of all the partners. When a partnership is dissolved, the partners claims against the assets are measured by the amount of the balances in their capital accounts.

Another characteristic of a partnership is mutual agency. This means that each partner is an agent of the partnership. The acts of each partner bind the entire partnership and become the obligations of all partners. For example, any partner can enter into a contract on behalf of all the members of the partnership. This is why partnerships should be formed only with people you trust.

An important right of partners is participation in income of the partnership. Net income and net loss are distributed among the partners according to their agreement.

A partnership , like a proprietorship, is a nontaxable entity and thus does not pay federal income taxes. However, revenue and expense and other results of partnership operations must be reported annually to the Internal Revenue Service. The partners must, in turn, report their share of partnership income on their personal tax returns.

A partnership is created by a contract, known as the partnership agreement or articles of partnership. It should include statements regarding such matters as amounts to be invested, limits on withdrawals, distribution of income and losses, and admission and withdrawal of partners.

A variant of the regular partnership is a limited partnership. A limited partnership is a unique legal form that allows partners who are not involved in the operations of the partnership to retain limited liability. In such a form at least one general partner must operate the partnership and retain unlimited liability. The remaining partners are considered limited partners 

The partnership form is less widely used than the proprietorship and corporate forms. For many business purposes, however, the advantages of the partnership form are greater than its disadvantages.

A partnership is relatively easy and inexpensive to organize, requiring only an agreement between two or more persons. A partnership has the advantage of bringing together more capital, managerial skills, and experience than does a proprietorship. Since a partnership is a non-taxable entity, the combined income taxes paid by the individual partners may be lower than the income taxes that would be paid by a corporation, which is a taxable entity.

A major disadvantage of the partnership is the unlimited liability feature for partners. Other disadvantages of a partnership are that its life is limited, and one partner can bind the partnership to contracts. Also, raising large amounts of capital is more difficult for a partnership than for a corporation. To overcome these limitations, other hybrid forms of organization, such as limited liability corporations (LLCs), have been replacing partnerships as a means of organization.

Limited Liability Corporations

A limited liability corporation (LLC) combines the advantages of the corporate and partnership forms. Many features of a partnership are retained in an LLC. The owners of an LLC are termed "members" rather than "partners" the members must create an operating agreement, which is similar to a partnership agreement. For example, the operating agreement normally indicates how income is to be distributed to the members. Thus, unlike a corporation, income need not be distributed according to the number of shares owned by each member. Instead, income might be distributed according to the amount of time each member devotes to the business.

For tax purposes, an LLC may elect to be treated as a partnership. In this way, income passes through the LLC and is taxed on the individual members' tax returns. Plus, the LLC may avoid the double taxation characterized by the corporate form.

Unless specified in the operating agreement, LLCs have a limited life and must dissolve when a member withdraws. In addition, the members may elect to operate the LLC as a "member-managed" entity, which allows individual members to legally bind the LLC, like partners bind a partnership.

LLCs also have some features of a corporation. One of the most important corporate features is that LLCs provide limited liability for the members, even if they are active participants in the business. Thus, members' personal assets are not subject to claims by creditors of the LLC.

Like a corporation, LLCs file "articles of organization" with state governmental authorities. In addition, the LLC may elect to be "manager-managed" rather than "member-managed." In a "manager-managed" structure, only authorized members may legally bind the LLC. This allows members to share in the income of the LLC without being concerned about managing the business, much like stockholders of a corporation.

Comparison of Alternate Identity Characteristics 

You can't make an assumption that one form is better than another. Generally, the corporate form will be preferred if the business is risky and requires access to capital. Otherwise, the other three forms all have their advantages. Depending on the need for simplicity, liability limitation, flexibility, and tax considerations. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 518-521*

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