Accounting: The Language of Business (Part 83)

The Macau casinos have a wonderful business, it's taking in money from Chinese businessmen elsewhere who send it through junky companies to casinos to gamble. The growth continues and they have basically western managers and western accounting, so we trust the numbers a little bit more.

James Chanos

Accounting for Partnerships and Limited Liability Corporations (Part D)

by

Charles Lamson

Partnership Dissolution

When a partnership dissolves, its affairs are not necessarily finished. For example, a partnership of two partners may admit a third partner. Or if one of the partners in a business withdraws, the remaining partners may continue to operate the business. In such cases, a new partnership is formed and a new partnership agreement should be prepared. Many partnerships provide for the admission of new partners and partner withdrawals in the partnership agreement so that the partnership may continue operations without having to execute a new agreement.

Admitting a Partner

A person may be admitted to a partnership only with the consent of all the current partners by:

 

1. Purchasing an interest from one or more of the common partners.

2. Contributing assets to the partnership.

When the first method is used the equity of the incoming partner is obtained from current partners, and neither the total assets nor the total owner's equity of the business is affected. When the second method is used, both the total assets and the total owner's equity of the business are increased. In the following paragraphs, we discuss each of these methods.

Purchasing an Interest in a Partnership

The purchase and sale of a partnership interest occurs between the new partner and the existing partners acting as individuals. The only entry needed is to transfer owner's equity amounts from the capital accounts of the selling partners to the capital account established for the incoming partner.

As an example, assume that partners Tom Andrews and Nathan Bell have capital balances of $50,000 each. On June 1, each sells 1/5 of his equity to Joe Canter for $10,000 in cash. The exchange of cash is not a partnership transaction and thus is not recorded by the partnership. The only entry required in the partnership accounts is as follows:

The effect of the transaction on the partnership accounts is presented in the following diagram:

The preceding entry is not affected by the amount paid by Canter for the 1/5 interest. Any gain or loss on the side of the partnership interest accrues to the selling partners as individuals, not to the partnership. Thus, in either case, the entry to transfer the capital interests is the same as shown above.

After Canter is admitted to the partnership, the total owners' equity of the firm is still $100,000. Canter now has a 1/5 interest, or a $20,000 capital balance. However, Canter may not be entitled to a 1/5 share of the partnership net income. The division of the net income or net loss will be made according to the new partnership agreement.

Contributing Assets to a Partnership

When a new partner is admitted by contributing assets to the partnership, both the assets and the owners' equity of the firm increase. For example, assume that Donald Lewis and Gerald Martin are partners with capital accounts of $35,000 and $25,000. On June 1, Sharon Nelson invests $20,000 cash in the business for ownership equity of $20,000. The entry to record this transaction is as follows:

The major difference between admitting Nelson and admitting Canter in the preceding example may be observed by comparing the following diagram with the preceding diagram.

By admitting Nelson, the total owners' equity of the new partnership becomes $80,000, of which Nelson has a 1/4 interest, or $20,000. The extent of Nelson's share in partnership net income will be determined by the partnership agreement.

Revaluation of Assets

A partnership's asset account balances should be stated at current values when a new partner is admitted. If the accounts do not approximate current market values, the accounts should be adjusted. The net adjustment (increase or decrease) in asset values is divided among the capital accounts of the existing partners according to their income-sharing ratio. Failure to adjust the accounts for current values may result in the new partner sharing in asset gains or losses that arose in prior periods.

To illustrate, assume that in the preceding example for the Lewis and Morton partnership, the balance of the merchandise inventory account is $14,000 and the current replacement value is $17,000. Assuming that Lewis and Morton share net income equally, the revaluation is recorded as follows:

Partner Bonuses

When a new partner is admitted to a partnership, the incoming partner may pay a bonus to the existing partners for the privilege of joining the partnership. Such a bonus is usually paid expecting high partnership profits in the future due to the contributions of the existing partners. Alternatively, the existing partners may pay the incoming partner a bonus to join the partnership. In this case, the bonus is usually paid recognizing special qualities or skills that the incoming partner is bringing to the partnership. For example, celebrities such as actors, musicians, or sports figures often provide name recognition that is expected to increase partnership profits in the future.

The amount of any bonus paid to the partnership is distributed among the partner capital accounts. To illustrate, assume that on March 1 the partnership of Marcia Jenkins and Helen Kramer is considering admitting a new partner, Alex Diaz. After the assets of the partnership have been adjusted to current market values, the capital balance of Jenkins is $20,000 and the capital balance of Kramer is $24,000. Jenkins & Kramer agree to admit Diaz to the partnership for $31,000. In return, Diaz will receive a 1/3 equity in the partnership and will share equally with Jenkins and Kramer in partnership income or losses.

In this case, Diaz is paying Jenkins & Kramer a $6,000 bonus to join the partnership. This bonus is computed as follows:

The bonus is distributed to Jenkins & Kramer according to their income-sharing ratio. Assuming that Jenkins & Kramer share profits and losses equally, the entry to record the admission of Diaz to the partnership is as follows:

If a new partner possesses unique qualities or skills, the existing partners may agree to pay the new partner a bonus to join the partnership. To illustrate, assume that after adjusting assets to market values, the capital balance of Janice Cowen is $80,000 and the capital balance of Steve Dodd is $40,000. Cowan & Dodd agree to admit Helen Chou to the partnership on June 1 for an investment of $30,000. In return, Chou will receive a 1/4 equity interest in the partnership and will share in 1/4 of the profits and losses. In this case, Cowan and Dodd are paying Chou a $7,500 bonus to join the partnership. This bonus is computed as follows:

Assuming that the income-sharing ratio of Collin and Dodd was 2:1 before the admission of Chou, the entry to record the bonus and admission of Chou to the partnership is as follows:

Withdrawal of a Partner 

When a partner retires or withdraws from a partnership, one or more of the remaining partners may buy the withdrawing partner's interest. The firm may then continue its operations uninterrupted. In such cases, the purchase and sale of the partnership interest is between the partners as individuals. The only entry on the partnership's records is to debit the capital account of the partner withdrawing and to credit the capital account of the partner or partners buying the additional interest.

If the withdrawing partner sells the interest directly to the partnership, both the assets and the owner's equity of the partnership are reduced. Before the sale, the asset accounts should be adjusted to current values, so that the withdrawing partner's equity may be accurately determined. The net amount of the adjustment should be divided among the capital accounts of the partners according to their income-sharing ratio. If not enough partnership cash or other assets are available to pay the withdrawing partner, a liability may be created (credited) for the amount owed the withdrawing partner.

Death of a Partner

When a partner dies, the accounts should be closed as of the date of death. The net income for the current year should be determined and divided among the partners' capital accounts. The balance in the capital account of the deceased partner is then transferred to a liability account with the deceased's estate. The remaining partner or partners may continue the business or terminate it. If the partnership continues in business, the procedures for settling with the estate are the same as those discussed for the withdrawal of a partner. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 528-531*

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