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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