Financial Accounting 2

ACC203 Financial Accounting 2

Workshop 2: Partnerships

COMMONWEALTH OF AUSTRALIA Copyright Regulations 1969

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Material adapted from Financial accounting / John Hoggett, John Medlin, Keryn Chalmers, Claire Beattie, Andreas Hellmann, Jodie Maxfield Tenth edition. John

Wiley & Sons Australia, Ltd

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2

Learning objectives

1. Understand the definition, the major attributes, advantages and special features of a partnership

2. Explain the accounting entries for the formation of a partnership

3. Explain the accounting entries for the allocation of profits and losses of a partnership

4. Explain the accounting entries for drawings and advances or loans made by partners

5. Describe the content of the financial statements of a partnership.

Learning objectives

1. Understand the definition, the major attributes, advantages and special features of a partnership

2. Explain the accounting entries for the formation of a partnership

3. Explain the accounting entries for the allocation of profits and losses of a partnership

4. Explain the accounting entries for drawings and advances or loans made by partners

5. Describe the content of the financial statements of a partnership.

Class Discussion In ACC201, you learnt accounting for sole proprietors. In this unit, ACC203, you will now learn about partnerships and companies.

Working in groups, discuss and answer the following questions:

1. What are the key differences between a sole trader and a partnership?

2. What advantages does a partnership have over a sole trader?

3. Are there any disadvantages of a partnership?

What is a partnership?

• Partnership Act: – The relationship that ‘subsists between persons

carrying on a business in common with a view to profit’.

• Three attributes are necessary:

Must be an agreement (verbal or written) between two or more legally competent persons.

The business must be operated with a view to earning a

profit.

Members must be co‐owners of the

business.

Advantages of a partnership

• The advantages of a partnership over other forms:

It permits the pooling of both capital

resources and the multiple skills of the individual partners.

It is easier and less costly to establish than a company.

It is not subject to as much government

regulation and supervision as

companies.

Partners may be able to operate with

more flexibility There may be certain

tax advantages.

Characteristics of a partnership

• Characteristics of a partnership

Mutual agency:

• Each partner acts as agent for the partnership and for every other partner.

• This is known as mutual agency.

Unlimited liability:

• Each partner is personally liable for the obligations of the partnership.

• This is termed unlimited liability.

Limited life:

• A partnership is dissolved for a number of reasons.

• Including the death of a partner, the bankruptcy of the partnership or an individual partner.

Transfer of partnership

interest:

• A capital interest in a partnership is a personal asset of the individual partner that can be sold or disposed of legally.

Class Activity

‘The big disadvantage of a sole trader business is that the personal liability of the owner is unlimited — the owner could lose everything. I think I will take on a partner and convert my business to a partnership. That way I will certainly reduce the chances of losing my personal assets if the business fails.’

Discuss.

Learning objectives

1. Understand the definition, the major attributes, advantages and special features of a partnership

2. Explain the accounting entries for the formation of a partnership

3. Explain the accounting entries for the allocation of profits and losses of a partnership

4. Explain the accounting entries for drawings and advances or loans made by partners

5. Describe the content of the financial statements of a partnership.

Accounting for a partnership

• Partnerships are non-reporting entities. • They do not have to comply with accounting standards • A major difference is accounting for the partners’ equity.

– the Capital investment and drawings of each partner vary over time.

– the profit or loss reported each accounting period is distributed to the partners in accordance with the partnership agreement.

Formation of a partnership

The capital interest each partner is to receive

should be agreed on and specified in the

partnership agreement.

The agreement is made, entries to record the

formation of a partnership can be

made.

We should always consider the fair value of the assets and liabilities being brought into the partnership rather than

the book values.

Formation of a partnership

Assuming that the partners agree to have capital balances equal to the fair value of net assets contributed and that GST is not applicable journal entries to record the initial investment are:

Class Activity

• Liam sold his partnership interest to Jason even though his other partners were unaware that Liam intended to do so. A. Does Jason have the right to be a partner? B. Does Jason have the right to take over Liam’s

position as manager of the business? C. Will Jason be entitled to share in the partnership

profits and, if so, how much?

Class Activity

Learning objectives

1. Understand the definition, the major attributes, advantages and special features of a partnership

2. Explain the accounting entries for the formation of a partnership

3. Explain the accounting entries for the allocation of profits and losses of a partnership

4. Explain the accounting entries for drawings and advances or loans made by partners

5. Describe the content of the financial statements of a partnership.

Accounting for a partnership

Method 1: Capital accounts that include profits and losses. • The Capital account of each

partner is credited when assets are invested in the partnership by that partner.

• Drawings account is debited to record the withdrawal of assets or the payment of personal expenses by an individual partner from partnership assets.

• Drawings account of each partner is typically closed to his or her Capital account.

Method 2: Fixed Capital accounts.

• The Capital account of each partner is credited when assets are invested in the partnership by that person.

• Drawings account is debited only for withdrawals of assets or the payment of personal expenses by the partner out of his or her share of profits or expected profits.

• The Drawings account of each partner is closed to the Retained Earnings account for each partner.

Allocation of partnership profits and losses

The partners should consider the three distinct elements that make up partnership profits:

A return for the personal services performed by the

partners.

A return on the capital provided by the partners.

A return for the business risks

assumed by the partners.

Allocation of partnership profits and losses

• Fixed ratio: – The simplest profit and loss agreements is for

each partner to be allocated profits or losses based on some specified ratio.

– This method may be appropriate if the partners’ contribution can be stated in terms of a fixed percentage.

Allocation of partnership profits and losses

• Ratio based on capital balances: – The allocation of profits based on the ratio of

capital balances may result in an equitable allocation when invested capital is considered the most important factor and/or the partnership operations require little of the partners’ time.

– The capital balances may change during the period whether method 1 or method 2 is in use.

Allocation of partnership profits and losses

• Fixed ratio after allowing for interest and salaries: – Often, individual partners make unequal

capital contributions and the amount of time and the nature of services performed are not the same.

– A profit allocation method that contains a provision for interest and/or salaries must be included in the partnership agreement.

Class Activity

Class Activity

Learning objectives

1. Understand the definition, the major attributes, advantages and special features of a partnership

2. Explain the accounting entries for the formation of a partnership

3. Explain the accounting entries for the allocation of profits and losses of a partnership

4. Explain the accounting entries for drawings and advances or loans made by partners

5. Describe the content of the financial statements of a partnership.

Drawings and loans made by partners

• Drawings: Partners may withdraw cash or other assets from the partnership to provide for their everyday living needs.

Under method 1,

• no distinction is made between withdrawals of capital and withdrawals of profits, hence all withdrawals are debited to the Drawings account of the partners and credited to Cash at Bank.

Under method 2,

• the withdrawal of capital by Cook is debited directly to his Capital account, and other drawings are taken to Retained Earnings.

Drawings and loans made by partners

• Interest on drawings: – Interest on drawings is not normally paid by

the partners into the partnership but is added to the profit distribution account and deducted from the Capital (method 1) or Retained Earnings (method 2) accounts of each partner at the end of the year.

Drawings and loans made by partners

• Loans or advances by partners: – A partner may lend money to the partnership

rather than investing the money in the business as a further capital contribution.

– Such an advance of money is correctly treated as a current and/or non‐current liability of the partnership and is accounted for using the following entry (in general journal form).

Class Activity

‘Partners’ advances and capital both represent money contributed to the partnership by the partners. Therefore, the accounting treatment for interest paid on advances and capital should be the same.’

Discuss.

Learning objectives

1. Understand the definition, the major attributes, advantages and special features of a partnership

2. Explain the accounting entries for the formation of a partnership

3. Explain the accounting entries for the allocation of profits and losses of a partnership

4. Explain the accounting entries for drawings and advances or loans made by partners

5. Describe the content of the financial statements of a partnership.

Financial statements for a partnership

• If the partnership is not a reporting entity, it will prepare special purpose financial statements, and this must be clearly stated.

• If the partnership is a reporting entity, then it must prepare general purpose financial reports complying with accounting standards.

• Each partner’s equity in the business is reported separately on the balance sheet or in a separate statement of changes in partners’ equity.

Financial statements for a partnership

• Salaries authorised for each partner, interest on capital investments and interest on drawings are not reported as expenses but recognised as an allocation of profit.

• There is no income tax expense since a partnership is not a legal entity and not subject to tax.

• The profit or loss allocation for the period is normally disclosed in the financial statements in a separate statement of changes in partners’ equity.

Class Activity

Class Activity

References

• Hoggett, J. , Medlin J., Chalmers K., Beattie C., Hellmann A. and Maxfield J., (2018) Financial Accounting 10th edn. Australia: John Wiley, pp.360-395.

End of the Workshop