Partnerships: Advantages and Accounting

In this article we will discuss about:- 1. Partnerships—Advantages and Disadvantages 2. Partnership Accounting—Capital Accounts.

Partnerships—Advantages and Disadvantages:

The popularity of partnerships derives from several advantages inherent to this type of orga­nization. An analysis of these attributes explains why nearly 3.6 million enterprises in the United States are partnerships rather than corporations.

One of the most common motives is the ease of formation. Only an oral agreement is nec­essary to create a legally binding partnership. In contrast, depending on specific state laws, incorporation requires filing a formal application and completing various other forms and doc­uments. Operators of small businesses may find the convenience and reduced cost involved in creating a partnership to be an especially appealing characteristic.

As the American Bar Association noted:

The principal advantage of partnerships is the ability to make virtually any arrangements defin­ing their relationship to each other that the partners desire. There is no necessity, as there is in a corporation, to have the ownership interest in capital and profits proportionate to the invest­ment made; and losses can be allocated on a different basis from profits.

It is also generally much easier to achieve a desirable format for control of the business in a partnership than in a corporation, since the control of a corporation, which is based on ownership of voting stock, is much more difficult to alter.

Partnerships are taxed on a conduit or flow-through basis under subchapter K of the Internal Revenue Code. This means that the partnership itself does not pay any taxes. Instead the net income and various deductions and tax credits from the partnership are passed through to the partners based on their respective percentage interest in the profits and losses of the partnership, and the partners include the income and deductions in their individual tax returns.

Thus, partnership revenue and expense items (as defined by the tax laws) must be assigned directly each year to the individual partners who pay the income taxes. Passing income bal­ances through to the partners in this manner avoids double taxation of the profits that are earned by a business and then distributed to its owners. A corporation’s income is taxed twice- when earned and again when conveyed as a dividend. A partnership’s income is taxed only at the time that the business initially earns it.

For example, assume that a business earns $100. After paying any income taxes, the remain­der is immediately conveyed to its owners. An income tax rate of 30 percent is assumed for both individuals and corporations. Corporate dividends paid to owners, however, are taxed at a 15 percent rate.

As the following table shows, if this business is a partnership rather than a corporation, the owners have $10.50 more expendable income, which is 10.5 percent of the busi­ness income. Although significant in amount, this difference narrows as tax rates are lowered.

Historically, a second tax advantage has long been associated with partnerships. Because income is taxable to the partners as the business earns it, any operating losses can be used to reduce their personal taxable income directly. In contrast, a corporation is viewed as legally separate from its owners, so losses cannot be passed through to them.

A corporation has the ability to carry back any net operating losses and reduce previously taxed income (usually for the two prior years) and carry forward remaining losses to decrease future taxable income (for up to 20 years). However, if a corporation is newly formed or has not been profitable, operat­ing losses provide no immediate benefit to a corporation or its owners as losses do for a part­nership.

The tax advantage of deducting partnership losses is limited however. For tax purposes, ownership of a partnership is labeled as a passive activity unless the partner materially partic­ipates in the actual business activities. Passive activity losses thus serve only to offset other passive activity profits.

In most cases, these partnership losses cannot be used to reduce earned income such as salaries. Thus, unless a taxpayer has significant passive activity income (from rents, for example), losses reported by a partnership create little or no tax advantage unless the partner materially participates in the actual business activity.

The partnership form of business also has certain significant disadvantages. Perhaps the most severe problem is the unlimited liability that each partner automatically incurs. Partner­ship law specifies that any partner can be held personally liable for all debts of the business. The potential risk is especially significant when coupled with the concept of mutual agency.

This legal term refers to the right that each partner has to incur liabilities in the name of the partnership. Consequently, partners acting within the normal scope of the business have the power to obligate the company for any amount. If the partnership fails to pay these debts, cred­itors can seek satisfactory remuneration from any partner that they choose.

Such legal concepts as unlimited liability and mutual agency describe partnership charac­teristics that have been defined and interpreted over a number of years. To provide consistent application across state lines in regard to these terms as well as many other legal aspects of a partnership, the Uniform Partnership Act (UPA) was created.

This act, which was first pro­posed in 1914 (and revised in 1997), now has been adopted by all states in some form. It estab­lishes uniform standards in such areas as the nature of a partnership, the relationship of the partners to outside parties, and the dissolution of the partnership. For example, Section 6 of the act provides the most common legal definition of a partnership- “an association of two or more persons to carry on a business as co-owners for profit.”

Partnership Accounting—Capital Accounts:

Despite legal distinctions, questions should be raised as to the need for an entirely separate study of partnership accounting:

i. Does an association of two or more persons require accounting procedures significantly different from those of a corporation?

ii. Does proper accounting depend on the legal form of an organization?

The answers to these questions are both yes and no. Accounting procedures are normally stan­dardized for assets, liabilities, revenues, and expenses regardless of the legal form of a busi­ness. Partnership accounting, though, does exhibit unique aspects that warrant study, but they lie primarily in the handling of the partners’ capital accounts.

The stockholders’ equity accounts of a corporation do not correspond directly with the cap­ital balances found in a partnership’s financial records. The various equity accounts reported by an incorporated enterprise display a greater range of information. This characteristic reflects the wide variety of equity transactions that can occur in a corporation as well as the influence of state and federal laws. Government regulation has had enormous effect on the accounting for corporate equity transactions in that extensive disclosure is required to protect stockholders and other outside parties such as potential investors.

To provide adequate information and to meet legal requirements, corporate accounting must provide details about numerous equity transactions and account balances. For example, the amount of a corporation’s paid-in capital is shown separately from earned capital and other comprehensive income; the par value of each class of stock is disclosed; treasury stock, stock options, stock dividends, and other capital transactions are reported based on prescribed accounting principles.

In comparison, partnerships provide only a limited amount of equity disclosure primar­ily in the form of individual capital accounts that are accumulated for every partner or every class of partners. These balances measure each partner or group’s interest in the book value of the net assets of the business. Thus, the equity section of a partnership balance sheet is composed solely of capital accounts that can be affected by many different events- contributions from partners as well as distributions to them, earnings, and any other equity transactions.

However, partnership accounting makes no differentiation between the various sources of ownership capital. Disclosing the composition of the partners’ capital balances has not been judged necessary because partnerships have historically tended to be small with equity trans­actions that were rarely complex. Additionally, absentee ownership is not common, a factor that minimizes both the need for government regulation and outside interest in detailed infor­mation about the capital balances.

Articles of Partnership:

Because the demand for information about capital balances is limited, accounting principles specific to partnerships are based primarily on traditional approaches that have evolved over the years rather than on official pronouncements. These procedures attempt to mirror the rela­tionship between the partners and their business especially as defined by the partnership agreement.

This legal covenant, which may be either oral or written, is often referred to as the articles of partnership and forms the central governance for a partnership’s operation. The financial arrangements spelled out in this contract establish guidelines for the various capital transactions. Therefore, the articles of partnership, rather than either laws or official rules, pro­vide much of the underlying basis for partnership accounting.

Because the articles of partnership are a negotiated agreement that the partners create, an unlimited number of variations can be encountered in practice. Partners’ rights and responsi­bilities frequently differ from business to business. Consequently, firms often hire accountants in an advisory capacity to participate in creating this document to ensure the equitable treat­ment of all parties.

Although the articles of partnership may contain a number of provisions, an explicit understanding should always be reached in regard to the following:

i. Name and address of each partner.

ii. Business location.

iii. Description of the nature of the business.

iv. Rights and responsibilities of each partner.

v. Initial contribution to be made by each partner and the method to be used for valuation.

vi. Specific method by which profits and losses are to be allocated.

vii. Periodic withdrawal of assets by each partner.

viii. Procedure for admitting new partners.

ix. Method for arbitrating partnership disputes.

x. Life insurance provisions enabling remaining partners to acquire the interest of any deceased partner.

xi. Method for settling a partner’s share in the business upon withdrawal, retirement, or death.

Accounting for Capital Contributions:

Several types of capital transactions occur in a partnership: allocation of profits and losses, retirement of a current partner, admission of a new partner, and so on. The initial transaction, however, is the contribution the original partners make to begin the business. In the simplest situation, the partners invest only cash amounts. For example, 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 this partnership follows:

The assumption that only cash was invested avoids complications in this first illustration. Often, though, one or more of the partners transfers noncash assets such as inventory, land, equipment, or a building to the business. Although fair value is used to record these assets, a case could be developed for initially valuing any contributed asset at the partner’s current book value.

According to the concept of unlimited liability (as well as present tax laws), a partner­ship does not exist as an entity apart from its owners. A logical extension of the idea is that the investment of an asset is not a transaction occurring between two independent parties such as would warrant revaluation. This contention holds that the semblance of an arm’s-length trans­action is necessary to justify a change in the book value of any account.

Although retaining the recorded value for assets contributed to a partnership may seem rea­sonable, this method of valuation proves to be inequitable to any partner investing appreciated property. A $50,000 capital balance always results from a cash investment of that amount, but recording other assets depends entirely on the original book value.

For example, should a partner who contributes a building having a recorded value of $18,000 but a fair value of $50,000 be credited with only an $18,000 interest in the partnership? Since $50,000 in cash and $50,000 in appreciated property are equivalent contributions, a $32,000 dif­ference in the partners’ capital balances cannot be justified. To prevent such inequities, each item transferred to a partnership is initially recorded for external reporting purposes at current value.

Requiring revaluation of contributed assets can, however, be advocated for reasons other than just the fair treatment of all partners. Despite some evidence to the contrary, a partnership can be viewed legitimately as an entity standing apart from its owners. As an example, a part­nership maintains legal ownership of its assets and (depending on state law) can initiate law­suits. For this reason, accounting practice traditionally has held that the contribution of assets (and liabilities) to a partnership is an exchange between two separately identifiable parties that should be recorded based on fair values.

The determination of an appropriate valuation for each capital balance is more than just an accounting exercise.

Over the life of a partnership, these figures serve in a number of impor­tant capacities:

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.

To demonstrate, assume that Carter invests $50,000 in cash to begin the partnership and Green contributes the following assets:

As an added factor, 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:

We should make one additional point before leaving this illustration. Although having contributed inventory, land, and a building, Green holds no further right to these individual assets; they now belong to the partnership. The $43,400 capital balance represents an owner­ship interest in the business as a whole but does; not constitute a specific claim to any asset. Having transferred title to the partnership, Green has no more right to these assets than does Carter.

Intangible Contributions:

In forming a partnership, the contributions made by one or more of the partners may go beyond assets and liabilities. A doctor, for example, can bring a particular line of expertise to a partnership, and a practicing dentist might have already developed an established clientele.

These attributes, as well as many others, are frequently as valuable to a partnership as cash and fixed assets. Hence, formal accounting recognition of such special contributions may be appropriately included as a provision of any partnership agreement.

To illustrate, assume that James and Joyce plan to open an advertising agency and decide to organize the endeavor 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.

Therefore, in producing the articles of partnership, the partners agree to start the business with equal capital balances. Often such decisions result only after long, and sometimes heated, negotiations. Because the value assigned to an intangi­ble contribution such as artistic talent is arbitrary at best, proper reporting depends on the part­ners’ ability to arrive at an equitable arrangement.

In recording this agreement, James and Joyce have two options:

(1) The bonus method and (2) the goodwill method. Each of these approaches achieves the desired result of establishing equal capital account balances. Recorded figures can vary significantly, however, depending on the procedure selected. Thus, the partners should reach an understanding prior to beginning business operations as to the method to be used. The accountant can help avoid conflicts by assisting the partners in evaluating the impact created by each of these alternatives.

(1) The Bonus Method:

The bonus method assumes that a specialization such as Joyce’s artistic abilities does not constitute a recordable partnership asset with a measurable cost. Hence, this approach recognizes only the assets that are physically transferred to the business (such as cash, patents, and inventory).

Although these contributions determine total partnership capital, the establishment of specific capital balances is viewed as an independent process based solely on the partners’ agreement. Because the initial equity figures result from negotiation, they do not need to correspond directly with the individual investments.

James and Joyce have contributed a total of $80,000 in identifiable assets to their partner­ship and have decided on equal capital balances. According to the bonus method, this agree­ment is fulfilled simply by splitting the $80,000 capital evenly between the two partners.

The following entry records the formation of this partnership under this assumption:

Joyce received a capital bonus here of $30,000 (the $40,000 recorded capital balance in excess of the $10,000 cash contribution) from James in recognition of the artistic abilities she brought into the business.

(2) The Goodwill Method:

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. In the present illustration, Joyce invested $60,000 less cash than James but receives an equal amount of capital according to the partnership agreement. Proponents of the good­will method argue that 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.

Comparison of Methods:

Both approaches achieve the intent of the partnership agreement- to record equal capital balances despite a difference in the partners’ cash contributions. The bonus method allocates the $80,000 invested capital according to the percentages designated by the partners, whereas the goodwill method capitalizes the implied value of Joyce’s intangible contribution.

Although nothing prohibits the use of either technique, the recognition of goodwill poses definite theoretical problems. In the discussions of both the equity method and purchase consolidations, goodwill was recorded but only as a result of an acquisition made by the reporting entity. Consequently, this asset had a historical cost in the traditional accounting sense. Partnership goodwill has no such cost; the business recognizes an asset even though no funds have been spent.

The partnership of James and Joyce, for example, is able to record $60,000 in goodwill without any expenditure. Furthermore, the value attributed to this asset is based solely on a negotiated agreement between the partners; the $60,000 balance has no objectively verifiable basis. Thus, although partnership goodwill is sometimes encountered in actual practice, this “asset” should be viewed with a strong degree of professional skepticism.

Additional Capital Contributions and Withdrawals:

Subsequent to forming a partnership, the owners may choose to contribute additional capital amounts during the life of the business. These investments can be made to stimulate expansion or to assist the business in overcoming working capital shortages or other problems.

Regard­less of the reason, the contribution is again recorded as an increment in the partner’s capital account based on fair value. For example, assume that James decides to invest another $5.000 cash in the partnership to help finance the purchase of new office furnishings. The partner’s capital account balance is immediately increased by this amount to reflect the transfer being made to the partnership.

The partners also may reverse this process by withdrawing assets from the business for their own personal use. For example, one partnership, Andersons, reported recently in its financial statements partner withdrawals of $1.759.072 for the year as well as increases in invested capital of $733.675. To protect the interests of the other partners, the articles of part­nership should clearly specify the amount and timing of such withdrawals.

In many instances, the articles of partnership allow withdrawals on a regular periodic basis as a reward for ownership or as compensation for work done in the business. Often such dis­tributions are recorded initially in a separate drawing account that is closed into the individual partner’s capital account at year-end. Assume, for illustration purposes, that James and Joyce take out $1,200 and $1,500, respectively, from their business.

The journal entry to record these payments is as follows:

Larger amounts might also be withdrawn from a partnership on occasion. A partner may have a special need for money or just desire to reduce the basic investment that has been made in the business. Such transactions are usually sporadic occurrences and entail amounts signif­icantly higher than the partner’s periodic drawing. The articles of partnership may require prior approval by the other partners.

Allocation of Income:

At the end of each fiscal period, partnership revenues and expenses are closed out with the resulting net income or loss being reclassified to the partners’ capital accounts. Because a sep­arate capital balance is maintained for each partner, a method must be devised for this assign­ment of annual income. Because of the importance of the process, the articles of partnership should always stipulate the procedure the partners established.

If no arrangement has been specified, state partnership law normally holds that all partners receive an equal allocation of any income or loss earned by the business. If an agreement has been set forth specifying only the division of profits, any subsequent losses must be divided in that same manner.

An allocation pattern can be extremely important to the success of an organization because it can help emphasize and reward outstanding performance.

Actual procedures for allocating profits and losses can range from the simple to the elaborate.

Partnerships can avoid all complications by assigning net income on an equal basis among all partners. Other organizations attempt to devise plans that reward such factors as the exper­tise of the individuals, number of years with the organization, or the amount of time that each works. Some agreements also consider the capital invested in the business as an element that should be recognized within the allocation process.

As an initial illustration, assume that Tinker, Evers, and Chance form a partnership by investing cash of $120,000, $90,000, and $75,000, respectively. The articles of partnership agreement specifies that Evers will be allotted 40 percent of all profits and losses because of previous business experience. Tinker and Chance are to divide the remaining 60 percent equally.

This agreement also stipulates that each partner is allowed to withdraw $10,000 in cash annually from the business. The amount of this withdrawal does not directly depend on the method utilized for income allocation. From an accounting perspective, the assignment of income and the setting of withdrawal limits are two separate decisions.

At the end of the first year of operations, the partnership reports net income of $60,000. To reflect the changes made in the partners’ capital balances, the closing process consists of the following two journal entries. The assumption is made here that each partner has taken the allowed amount of drawing during the year. In addition, for convenience, all revenues and expenses already have been closed into the Income Summary account.

Statement of Partners’ Capital:

Because a partnership does not separately disclose a retained earnings balance, the statement of retained earnings usually reported by a corporation is replaced by a statement of partners’ capital. The following financial statement is based on the data presented for the partnership of Tinker, Evers, and Chance.

The changes made during the year in the individual capital accounts are outlined along with totals representing the partnership as a whole:

Alternative Allocation Techniques—Example 1:

Assigning net income based on a ratio may be simple, but this approach is not necessarily equi­table to all partners. For example, assume that Tinker does not participate in the partnership’s operations but is the contributor of the highest amount of capital. Evers and Chance both work full-time in the business, but Evers has considerably more experience in this line of work.

Under these circumstances, no single ratio is likely to reflect properly the various contributions made by each partner. Indeed, an unlimited number of alternative allocation plans could be devised in hope of achieving fair treatment for all parties. For example, because of the different levels of capital being invested, consideration should be given to including interest within the allocation process to reward the contributions. A compensation allowance is also a possibility, usually in an amount corresponding to the number of hours worked or the level of a partner’s business expertise.

To demonstrate one possible option, assume that Tinker, Evers, and Chance begin their partnership based on the original facts except that they arrive at a more detailed method of allocating profits and losses. After considerable negotiation, an articles of partnership agree­ment credits each partner annually for interest in an amount equal to 10 percent of that part­ner’s beginning capital balance for the year.

Evers and Chance also will 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 going to Evers because of the work experience that this partner brings to the business. As with any appropriate allocation, this pattern attempts to provide fair treatment for all three partners.

Under this arrangement, the $60,000 net income earned by the partnership in the first year of operation would be prorated as follows. The sequential alignment of the various provisions is irrelevant except that the ratio, which is used to assign the remaining profit or loss, must be calculated last.

Alternative Allocation Techniques—Example 2:

As the preceding illustration indicates, the assignment process is no more than 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 partners’ imagination.

Although interest, compen­sation allowances, and various ratios are the predominant factors encountered in practice, other possibilities exist. Therefore, another approach to the allocation process is presented to further illustrate some of the variations that can be utilized. A two-person partnership is used here to simplify the computations.

Assume that Webber and Rice formed a partnership in 1995 to operate a bookstore. Webber contributed the initial capital, and Rice manages the business.

With the assistance of their accoun­tant, they wrote an articles of partnership agreement that contains the following provisions:

1. Each partner is allowed to draw $1,000 in cash from the business every month. Any with­drawal in excess of that figure will be accounted for as a direct reduction to the partner’s capital balance.

2. Partnership profits and losses will be allocated each year according to the following plan:

a. Each partner will earn 15 percent interest based on the monthly average capital balance for the year (calculated without regard for normal drawings or current income).

b. As a reward for operating the business, Rice is to receive credit for a bonus equal to 20 percent of the year’s net income. However, no bonus is earned if the partnership reports a net loss.

c. The two partners will divide any remaining profit or loss equally.

Assume that Webber and Rice subsequently begin the year 2009 with capital balances of $150,000 and $30,000, respectively. On April 1 of that year, Webber invests an additional $8,000 cash in the business, and on July 1, Rice withdraws $6,000 in excess of the specified drawing allowance. Assume further that the partnership reports income of $30,000 for 2009.

Because the interest factor established in this allocation plan is based on a monthly average figure, the specific amount to be credited to each partner is determined by means of a prelim­inary calculation:

Following this initial computation, the actual income assignment can proceed according to the provisions specified in the articles of partnership. The stipulations drawn by Webber and Rice must be followed exactly, even though the business’s $30,000 profit in 2009 is not suffi­cient to cover both the interest and the bonus. Income allocation is a mechanical process that should always be carried out as stated in the articles of partnership without regard to the spe­cific level of income or loss.

Based on the plan that was created, Webber’s capital increases by $21,675 during 2009 but Rice’s account increases by only $8,325: