Module 1: Partnership equity accounting...Module 1: Partnership equity accounting Overview In FA3,...

Module 1: Partnership equity accounting

Overview

In FA3, liability and equity issues dominate your in-depth study of the financial reporting model. This module addresses equity accounting issues in the context of a partnership. Partnerships are often less complex than corporations, but can have some interesting twists. This module reviews the basic legal structure of a partnership and explores various accounting issues such as partnership formation, dissolution, profit distributions, and admission and retirement of a partner. Computer activities cover the distribution of partnership income and liquidation using a spreadsheet program. The module concludes with a description of ethical accounting policy choice and an introduction to case analysis. You practise the case analysis approach introduced in this module as you work through the course.

Since many small businesses are organized as partnerships, this module is very practical if you deal with small businesses on a day-to-day basis.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.

Learning objectives

1.1 Describe the conceptual nature of ownership interests. (Level 2)

1.2 Explain the rights and obligations of a partner and the concept of mutual agency. (Level 2)

1.3 Explain how a partnership is created and dissolved. (Level 2)

1.4 Compare and contrast the elements of a general partnership and a limited partnership. (Level 2)

1.5 Account for the creation of a partnership and its ongoing operations, including the distribution of net income (loss) among the partners. (Level 1)

1.6 Account for admission, retirement, and withdrawal or death of a partner. (Level 1)

1.7 Account for the liquidation of a partnership. (Level 2)

1.8 Prepare, in good form, the financial statements for a partnership. (Level 1)

1.9 Explain the importance of accounting information and policy choice in contracting situations and describe some typical motivations for accounting policy choice. (Level 1)

1.10 Perform a simple case analysis: recognize the problem, identify and analyze policy choice alternatives, and provide an ethical recommendation. (Level 1)

Financial Accounting 3 [FA3]

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1.1 Theoretical foundation

Learning objective

� Describe the conceptual nature of ownership interests. (Level 2)

LEVEL 2

Partnerships

While corporations are the dominant form of organization for business activity in North America, many start out as partnerships or sole proprietorships. Other businesses are required to operate as sole proprietorships or partnerships because of the nature of their operations. This module critically analyzes accounting for ownership interests in partnerships.

In many ways, the issues surrounding partnerships are identical to the issues related to corporations. Owners create the entity and provide initial capital. Ownership interests change as profits are earned and are distributed, increase as owners invest additional capital, and decrease as capital is withdrawn. However, since the legal form of a partnership is different from that of a corporation, the accounting rules are also different. Some situations can only occur in a corporation — for example, a partnership cannot issue stock dividends. Other issues, such as profit allocations to individual owners, are unique to partnership accounting.

Nature of ownership interests

Business entities raise capital primarily from two sources: lenders and equity investors. Both expect a return from the entity — interest (for debt) or profit distributions (for equity), followed by eventual principal repayment (for debt) or return of equity capital.

Ownership theories attempt to describe the relationship between the business entity and the owners of the entity and other stakeholders — groups who have a vested interest in the entity's well-being and continued existence. Ownership theories are described as normative theories; they are based on standards or norms. They explain how owners' equity and income could or should be measured and reported rather than how they are reported.

Proprietary view

The proprietary view of an entity assumes that the firm and its owners are virtually one and the same; creditors are outsiders. This is a narrow view of the firm's activities and costs, focusing on the equity investor's perspective. Equity is defined as the residual interest in net assets. The accounting equation is

Assets – Liabilities = Equity

According to this view, the components of net income would include expenses for wages, interest, and taxes, but would not include distribution of profits to equity holders. Such profit distributions are the return on equity investment.

In a partnership, there is no legal distinction between a partner and the partnership. This is the ultimate application of the proprietary view. The partners experience the risks and rewards of the ownership of net assets, and they benefit when operations are profitable. (A partnership is also an interesting application of the separate entity assumption: legally, a partnership is not a separate entity, but it must be accounted for as if it


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were separate and distinct from the partners personally.)

Entity view

In contrast to the proprietary view, the entity view assumes that the firm has a separate existence apart from all groups of stakeholders. This is a broad view of the firm's activities and costs; it includes the perspective of all interested parties. Creditors, employees, governments, and owners have separate rights and interests in assets and operations. The accounting equation is

Assets = Total equities (Liabilities + Equity)

Equity investors do not "own" owners' equity, but have the residual claim to assets after other stakeholders are satisfied.

According to this theory, operations generate an operating income, which is then used to satisfy the claims of all stakeholders. Wages, interest, taxes, and profit distributions are all viewed as payments with equivalent status.

The difference between the proprietary view and the entity view is most clearly understood by contrasting an income statement (statement of operations) and a statement of retained earnings (statement of distribution of earnings) consistent with each view. See Exhibit 1.1-1 below.

Note: The correct use of accounting terms is an important part of your learning in this course. You will also learn, however, that there are several sources of authority for the "language of accounting."

An example of variations in terminology is the use of the term "income statement." These module notes and the textbook that accompanies them use the term "income statement." However, the term "statement of income," which is used in practice and in the Model Financial Statements produced by CGA-Canada, and the term "statement of earnings," which some academics prefer, are also acceptable. Either term will be acceptable in assignments or examinations.

Exhibit 1.1-1: Contrast between the proprietary view and the entity view

Proprietary view Entity view

Income statement year ended December 31, 20X1

Statement of operations year ended

December 31, 20X1

Sales $ 5,600 Sales $ 5,600

Cost of sales (2,900) Cost of sales (2,900)

Other expenses (1,000) Other expenses (1,000)

Wages expense (400) Operating income $ 1,700

Interest expense (200)

Tax expense (300)

Net income $ 800


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Exhibit 1.1-1 uses a corporation's financial statement format for both alternatives: distributions of profits are called dividends, and capital is divided into share equity and retained earnings. These accounts have different labels when accounting for a partnership (for example, one equity account summarizes both initial investment and retained profits, profit distributions are not called dividends). Don't dwell on these differences now. Focus instead on the general placement of payments to stakeholders.

Which view is more appropriate?

The proprietary view is consistent with the traditional income statement because all groups except owners are viewed as outsiders, and all charges relating to outsiders are on the income statement. However, take a moment to consider the entity view. Doesn't it make sense to acknowledge that employees, governments, the general public, and so on, have a vested interest in the firm?

Which view is closer to reality? Which view better represents the ethical responsibilities of the firm?

The answers to these questions depend on the situation. In many instances, liabilities are clearly obligations to outsiders, and the people who invest equity capital actually control the firm's operations. This is consistent with the proprietary view. In other cases, creditors or employees may have significant influence over the operation of the firm. This is consistent with the entity view.

In some large corporations, it is easy to see the application of the entity view; owners really are outside stakeholders who must be satisfied (compensated) for their investment and risk by an autonomous entity — the company. This argument is far more difficult to make for a partnership, since the partners are usually principals involved in the day-to-day operation of the business. Conceptually, the interests of the partners and the partnership are indivisible, and the proprietary view is appropriate.

In the case of the firm's ethical responsibilities, again, the answer is situational. The entity view certainly brings many more interests into play, but there is no reason ethical responsibilities would not be addressed from a proprietary perspective. Shareholders are motivated to address concerns that serve their legitimate long-term interests without taking advantage of other parties (government, employees, and so on). Based on the proprietary view, one acts ethically by staying within ethical limits or boundary conditions. As long as one stays "within bounds," one is ethically free to select from available options.

The proprietary and entity views of ownership interest reflect an important division in business ethics: for

Statement of retained earnings year ended December 31, 20X1

Statement of distribution of earnings year ended

December 31, 20X1

Opening retained earnings $ 2,100 Opening retained earnings $ 2,100

Plus: Net income $800 Plus: Operating income $ 1,700

Less: Dividends (250) 550 Less: Distribution to stakeholders

Closing retained earnings

$ 2,650

• employees (400)

• creditors (200)

• governments (300)

• equity investors (250) 550

Closing retained earnings $ 2,650


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whose benefit is the business run? Although they are not assigned as part of this course, you can find some related readings in this area in the Ethics Readings Handbook, Unit B2.

1.2 Nature of a partnership

Learning objective

� Explain the rights and obligations of a partner and the concept of mutual agency. (Level 2)

Required reading

� Hilton & Heraulf, "Accounting for Partnerships," Bonus Chapter 15 in Modern Advanced Accounting in Canada, Fourth Edition (Toronto, Ontario: McGraw-Hill, 2005), page 2 (Level 2).

� Reading 1.2-1, "Sole Proprietorships and Partnerships (To view the content from this link you must go on-line.)" The section entitled "The Relation of Partners to One Another" (pages 14-18) is particularly important because it outlines sections of the Partnership Act that deal with accounting. (Level 2)

LEVEL 2

Partners as agents

Agency is a legal relationship wherein one person (the agent) represents another (the principal) and can enter into contracts on behalf of the principal with third parties. Partners have a mutual agency relationship, as they commit each other to contracts through the partnership.

Legally and ethically, partnerships are trust arrangements. From an ethical (and legal liability) perspective, it is important to avoid partnerships with untrustworthy people, and it is essential to reciprocate trustworthy behaviour.

In a long-standing partnership, there should be a good track record of trustworthy behaviour among partners. In new partnerships, there should be reason to believe that one's partners are trustworthy. Of course, long-standing partners, as well as new partners, can let partners down and take advantage of the trust bestowed in them.

Because trust is fundamental to partnerships (compared to corporations with limited liabilities), an accountant has to consider fairness to all when giving advice in a partnership environment.

As an accountant, you are in a position to help people enter, maintain, and leave partnerships. Remember that unless there is a separate partnership agreement, the provincial Partnership Act will rule. Partners should carefully work through the implications of the Partnership Act and establish an arrangement that suits their individual needs.

Accountants are not expected to be able to give expert advice on the interpretation of the Partnership Act or on all aspects of partnership agreements. However, you must be able to explain the nature of a partnership, the common legal implications of partnerships, and the accounting implications of the Partnership Act.

Advantages and disadvantages of partnerships


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Some types of endeavours must be carried on through a partnership. For example, legal and accounting firms in some jurisdictions are, at present, not permitted to incorporate. Because these firms provide professional services, the legal structure is established to ensure that the partners' personal assets are at risk, or available, to those who rely on their professional judgment. In other words, the partners cannot hide behind the "corporate veil" of limited liability. This is one of the ways in which society signals high expectations for professionals.

Why might some other type of business choose to form a partnership rather than incorporate? There are some important advantages and disadvantages to each choice:

Partnerships

� There may be tax advantages for a partnership; a partnership is not a taxable entity. � Partners pay personal income tax based on their portion of total partnership income, whether

distributed to the partner as a withdrawal or retained in the partnership. � Partners' personal tax rates are low for low levels of income and climb for higher levels of

income. Losses from partnership activities may be netted against personal income from other sources.

� A partnership is easier to form than a corporation, with lower start-up costs. � A partnership is subject to less government regulation and fewer reporting requirements than a

corporation. � It may be difficult to transfer ownership interests. � Mutual agency applies. � Personal liability is unlimited. � The partnership dissolves at the death of one partner.

Corporation

� The liability of shareholders in a corporation is limited to their investment. � The life of a corporation is legally unlimited. � Ownership of the corporation is easily changed by selling shares. � There may be tax advantages. A corporation is a taxable entity; corporations pay tax on taxable

income, if any, after salary is paid to owner-employees. Corporate tax rates are constant over wide income levels and may be higher or lower than personal rates.

� Owners pay tax only on salary actually received. � Distributions of net income as dividends are taxable income to owners, but not tax deductible for

the corporation. � The corporation is more difficult to form and has more subsequent reporting obligations. � Shareholders cannot commit the organization or other shareholders to contracts.

1.3 Creation and termination of a partnership

Learning objective

� Explain how a partnership is created and dissolved. (Level 2)

Required reading


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� Review Reading 1.2-1, "Sole Proprietorships and Partnerships (To view the content from this link you must go on-line.)," pages 7-8 and 18-20 (Level 2)

LEVEL 2

Review the material indicated above from Reading 1.2-1 to understand the importance of a partnership agreement and what happens when the partnership is terminated.

Because the provincial Partnership Act will apply in all matters not set out in a formal partnership agreement, and because oral agreements are vulnerable to the shortfalls of memory and subjective interpretation, an agreement drafted with expert assistance is advisable. The reading provides a checklist of matters that should normally be covered in such an agreement. The agreement should also include provisions for termination of the partnership, including

� when the partnership can be terminated � how much notice is required � whether the remaining members will continue as partners � how the retiring (or departing or deceased) partner's share is to be valued � how the continuing partners will arrange to buy out this share

1.4 General and limited partnership

Learning objective

� Compare and contrast the elements of a general partnership and a limited partnership. (Level 2)

Required reading

� Reading 1.2-1, "Sole Proprietorships and Partnerships (To view the content from this link you must go on-line.)," pages 12-13 and 21 (Level 2)

LEVEL 2

Limited partnership

Many professional practice firms in the field of public accounting are organized as limited liability partnerships (LLP's). Limited partnerships have been a popular vehicle for financing real estate projects because they can provide tax advantages to limited partners. Specifically, a limited partner provides capital for a real estate project that is (hopefully) in a break-even position in terms of operating cash flow. The income statement shows losses, though, because of non-cash charges — amortization (or, for tax purposes, tax amortization, called capital cost allowance). The limited partners can claim their share of these losses against other earned income on their personal tax returns. Thus, part of the return the limited partners earn on their investment comes through tax relief. Of course, if the real estate project goes sour, the limited partners lose their invested capital, although none of their personal assets are at risk unless they become active in management.

Real estate is a volatile industry, and some projects have resulted in the loss of limited partners' capital investment. Have you ever observed that some investors take on great financial risk to reduce current taxes?


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Investment opportunities must be carefully evaluated.

1.5 Partnership contribution and profit distribution

Learning objective

� Account for the creation of a partnership and its ongoing operations, including the distribution of net income (loss) among the partners. (Level 1)

Required reading

� "Accounting for Partnerships," pages 2-5 (Level 1)

LEVEL 1

Overview of partnership profit allocation

For partnerships, allocation of profit is a major — and unique — accounting problem. There are an infinite number of ways that profits and losses can be allocated between partners. The accountant or lawyer should make sure that partners come to an explicit agreement on how their earnings are to be split. The accountant cannot decide this issue — the partners must form an agreement. Otherwise, the relevant Partnership Act will speak for them — a solution that may make no one happy.

Allocations can become very complex very quickly, especially when a number of factors enter into the picture, such as the size of partner investment, degree of involvement, and so on. If the partners are in agreement with respect to these key variables, fairly simple profit allocations will seem fair. If not, the complexities must be worked out. Accountants are usually involved in this process.

Computer activity 1.5-1: Allocation of net income to partners

The required reading explains the unique partnership accounts and provides examples of allocation of net income. The distribution of income and bonuses to partners in a partnership can pose some interesting computational problems. In this computer activity you use a worksheet to calculate a partnership income distribution.

Material provided

The file FA3M1P1 contains two worksheets:

M1P1 — a partially completed worksheet to calculate partnership profit distribution M1P1S — solution for the worksheet M1P1

Description

Malinski and Chong are partners in the accounting practice of Malinski & Chong, Certified General Accountants. Their capital account balances on January 1, 20X5, were $60,000 and $30,000, respectively. Their partnership agreement stipulates the following method of distributing partnership profits:


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To Malinski:

� salary of $36,000 � 5% interest on beginning capital balance � 60% of the residual profit or losses after total partner salaries and interest are paid

To Chong:

� salary of $56,000 � 5% interest on beginning capital balance � 40% of the residual profit or losses after total partner salaries and interest are paid

Required

The partnership net income before partner salaries and interest is $180,000. Calculate, using the worksheet FA3M1P1, the distribution of the 20X5 partnership profits. For each partner, calculate the partnership income as a percentage of the total profit.

Procedure

Perform the following steps:

1. Start Excel and open the file FA3M1P1. (Before you begin working on the data files in this course, you must first download them and save them to your hard drive. Click the data files link in the navigation pane, then follow the instructions for downloading and saving the files.)

2. Click the sheet tab for M1P1.

3. Observe rows 9 to 16 in the data table. The schedule of partnership profit distribution starts in row 21. This schedule is blank, except for column and row labels. Enter the appropriate formulas in rows 28 to 34, where required. Enter a formula in cell D32 to perform a cross-adding IF statement as a further test of accuracy. (In other words, if the sum of cells B32 to C32 equals the sum of cells D28 to D30, the result of the sum of cells B32 to C32 is displayed. Otherwise an error function is displayed.)

4. Save the file.

5. Print a copy of the completed worksheet.

6. To view the solution, click the sheet tab M1P1S. This worksheet contains the results you should have obtained if you have completed the worksheet correctly. If you had different results, make the appropriate changes.

1.6 Admission, retirement, and withdrawal or death of a partner

Learning objective


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� Account for admission, retirement, and withdrawal or death of a partner. (Level 1)

Required reading


LEVEL 1

Admitting a new partner

Whenever a new partner is admitted to an existing partnership, the old partnership is technically dissolved and a new one is formed. Although there are legal matters that must be considered, as long as the partnership agreement provides for continuity, the day-to-day operations of the firm are rarely affected. The old partnership agreement should be amended or a new one drawn up to reflect the change in the partnership. All the matters addressed previously, such as division of profit and loss, should be discussed and agreed on among the partners when amending or redrafting the partnership agreement.

Exhibit 1.6-1 summarizes the two general bases on which a new partner may be admitted to a firm, and alternatives to account for each.

Exhibit 1.6-1: Summary of alternative bases of admission

Goodwill

There are several ways the admission of a partner can be accounted for. One of these alternatives results in goodwill recognition.

Recording goodwill from the admission of a partner does not necessarily provide meaningful information to financial statement users, since it inflates assets and equities by including an intangible asset with an uncertain cost base on the balance sheet. Consequently, many accountants prefer to treat any excess paid by a new partner as a bonus to the old partners.

Goodwill must be evaluated annually for possible impairment of value. Goodwill is not amortized, but is written down if impaired. Impairment is uncertain and calls for estimation. Any impairment loss is a charge against income and will flow through the capital accounts on the allocation of income. If the partnership were liquidated, any remaining goodwill would probably be written off immediately since it would not have any realizable value on liquidation.

Retirement of a partner

On retirement, withdrawal, or death, a partnership is legally dissolved and all the partners must be paid out. The partnership agreement should specify the process on retirement, withdrawal, or death, especially if the surviving partners wish to continue in business together.

See Exhibit 1.6-2 for a summary of two alternate methods of retirement.

Exhibit 1.6-2: Two alternate methods of retirement


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1.6 Admission, retirement, and withdrawal or death of a partner - Content Links

Exhibit 1.6-1: Summary of alternative bases of admission

1. The new partner purchases all or part of the interest of one or more of the existing partners. On this basis, the new partner pays the old partner(s) directly, and no new assets come into the firm.

Accounting basis:

Method A: transfer portion of existing book value Method B: recognize goodwill based on price paid, then transfer portion of revised book value

Examples of these alternatives are on pages 6-7 of the text. Method A is the most commonly found in practice.

2. The new partner invests in the existing business by making a payment to the partnership. On this basis, the assets of the firm will increase.

Accounting basis:

Bonus method: New partner is given a proportionate interest in book value and assets invested above/below this amount are "bonused" (given or taken away from) the existing partners.

Asset revaluation method: New partner investment is used to imply a value for the partnership and existing assets are written down (or up) with the resulting loss or gain charged or credited to the existing partners. When assets must be written up, goodwill is often recognized.

Examples of these alternatives are on pages 7-11. The bonus method is the most commonly found in practice, except when the price paid by the new partner implies that assets are impaired, in which case assets will be written down.

Exhibit 1.6-2: Two alternate methods of retirement

The retiring partner will receive cash (or a promissory note) from the partnership; its net assets will decline. The alternatives are:

� Bonus method: The difference between the book value of the old partner's capital accounts and the payment recorded is bonused to (or taken away from) the old partners.

� Asset revaluation method: The price paid to the old partner is used to imply a value for the partnership and existing assets are written down (or up) with the resulting loss or gain charged or credited to both the old and new partners. When assets must be written up, goodwill is often recognized.


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1.7 Liquidation of a partnership

Learning objective

� Account for the liquidation of a partnership. (Level 2)

Required reading


LEVEL 2

Liquidation of a partnership means that the business comes to an end. The process of liquidation entails the following steps:

1. Realization (sale) of assets. All non-cash assets should be converted to cash. For example, amounts owing to the partnership should be collected, and other assets, such as inventory or capital assets, should be sold. The realization should be carried out with care to ensure that the maximum amount is received on the disposition of the assets.

2. Allocation of gains and losses. Any gains or losses realized on the disposition of assets should be allocated to the partners in their profit-and-loss-sharing ratio. The importance of allocating these gains and losses to the partners before any cash is distributed to them cannot be overemphasized.

3. Payment to creditors. Upon liquidation, the creditors of the firm rank ahead of the partners; therefore, creditors must be paid in full before any distribution is made to partners.

4. Payment of loans from partners. If the partners have made loans to the firm, they rank behind the creditors in payment preference. However, partners' loans must be settled before any distributions with respect to equity are made to partners.

5. Distribution of remaining assets to partners. After the first four steps have been carried out, the remaining assets may be distributed to the partners. If loans have been made to partners, the balance due to the partnership may be offset against the indebted partner's capital account before final distribution of equity is made.

Insolvency

On liquidation, a partnership may be solvent or insolvent. In an insolvent partnership, partnership liabilities exceed realizable assets. Accounting for an insolvent partnership is beyond the scope of this course.

Liquidation of a solvent partnership

In a solvent partnership, one of two situations can exist:

� The equity of each partner can absorb any losses on realization. This situation is illustrated in the required reading (pp. 12-14) and in the computer activity you will work through in the next section.

or


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� The equity of one or more partners is not sufficient to absorb the losses. This situation is illustrated in the required reading (p. 14-15) and in Activity 1.7-1 below.

Activity 1.7-1: Equity of one partner is insufficient to absorb losses

Able, Barker, and Chu are partners in a firm that is about to be liquidated. The partners have been sharing profits and losses equally. The balance sheet prior to liquidation is as follows:

Able, Barker, and Chu Partnership Balance sheet

as of liquidation date

The non-cash assets are sold for $22,000. Divide the loss of $45,000 among the partners and assume Chu pays in money to cover his debit balance.

Complete a schedule of partnership liquidation.

Solution

Assets Liabilities and partners' equity

Cash $ 8,000 Accounts payable $ 22,000

Other assets 67,000 Able, capital 19,000

Barker, capital 25,000

_______ Chu, capital 9,000

$75,000 $75,000

Assets Liabilities Partners' equity

Cash Non-Cash Creditors A Capital B Capital C Capital

Profit-and-loss ratio 1/3 1/3 1/3

Pre-liquidation balances $________ $________ $________ $________ $________ $________

Realization and loss $________ $________ $________ $________ $________ $________

Balances $________ $________ $________ $________ $________ $________

Payment to creditors $________ $________ $________ $________ $________ $________

Balances $_______ $_______ $_______ $_______ $_______ $_______

Payment from Chu $________ $________ $________ $________ $________ $________

Distribution to Able and Barker $________ $________ $________ $________ $________ $________

Balances $_______ $_______ $_______ $_______ $_______ $_______


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Computer activity 1.7-1: Sample partnership liquidation

Description

Assume that Belanger, Thibault, and Smithson have decided to liquidate their partnership as at December 31, 20X8. They have been sharing profits and losses in the ratio of 5:3:2. The balance sheet of the partnership after closing the books on December 31, 20X8, is as follows:

Belanger, Thibault, and Smithson Partnership Balance sheet

December 31, 20X8

Required

During liquidation, $15,000 is realized on the inventory and $41,000 on the other assets. The partners will share the $34,000 loss (proceeds of $56,000 realized versus cost of $90,000) on realization in their profit-and-loss ratio. The outside creditors will be paid, and the remaining cash will be distributed to the partners. Using worksheet FA3M1P2, calculate the liquidation of the partnership's assets and the final distribution to the partners. The liquidation schedule is shown as a worksheet.

Material provided

The file FA3M1P2 contains two worksheets:

M1P2 — a partially completed worksheet to calculate the schedule of partnership liquidation

M1P2S — solution for worksheet M1P2

Procedure

1. Start Excel and open the file FA3M1P2.

2. Click the sheet tab for M1P2.

3. Observe that rows 7 to 26 contain the data table. The schedule of liquidation starts in row 32. This schedule is blank, except for column and row labels.

4. Enter the appropriate formulas or cell references in rows 39, 41, and 42. In row 42, cash increases and assets decrease. The loss (decrease in assets versus increase in cash) is allocated to each partner using his or her ratio. Write formulas to reflect these facts.

5. Rows 44, 47, and 50 are simply sums of the previous two rows. Enter the appropriate formula in these rows.

Assets Liabilities and partners' equity

Cash $ 10,000 Accounts payable $ 13,000

Inventory 20,000 Belanger, capital 34,000

Other assets 70,000 Thibault, capital 23,000

Smithson, capital 30,000

$100,000 $100,000


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6. Enter the payment to creditors in row 45 using the appropriate formula. Cash and liabilities decrease.

7. Row 48 is used to calculate the distribution to the partners. Enter the necessary formulas in row 48.

Cash and equity decrease.

8. Save the file.

9. Print a copy of the completed worksheet.

10. To view the solution, click the sheet tab M1P2S. This worksheet contains the results you should obtain if you have completed the worksheet correctly. If your results were different, make the appropriate changes.

Instalment liquidation

Note: Extend your knowledge background information is not examinable.

1.7 Liquidation of a partnership - Content Links

Activity 1.7-1 solution

Dividing the loss of $45,000 among the partners creates a $6,000 debit balance in Chu's capital account, as shown in the following schedule of liquidation.

Able, Barker, and Chu Partnership Schedule of partnership liquidation

Assets Liabilities Partners' equity

Cash Non-cash Creditors A Capital B Capital C Capital

Profit-and-loss ratio 1/3 1/3 1/3

Pre-liquidation balances $ 8,000 $67,000 $(22,000) $(19,000) $ (25,000) $(9,000)

Realization and loss 22,000 (67,000) — 15,000 15,000 15,000

Balances $30,000 $ — $(22,000) $ (4,000) $ (10,000) $ 6,000

Payment to creditors (22,000) — 22,000 — — —

Balances $ 8,000 $ — $ — $(4,000) ($10,000) $6,000


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Chu has an obligation to pay the partnership $6,000; otherwise, Able and Barker will receive less than their equity in the partnership. If Chu is solvent and pays $6,000, the liquidation schedule would be completed as follows:

If Chu is insolvent and thus unable to pay the $6,000, the loss should be charged to Able and Barker in their proportionate profit-and-loss ratio. Since each had a 1/3 interest in profits, they have an equal (1/2) interest once C drops out. This is the scenario that is illustrated in the chapter material, on pages 14-15.

Instalment liquidation

It can take considerable time to fully liquidate a partnership, and the partners may well be unwilling to wait for final liquidation before receiving any payment from the partnership. Instalment payments may be authorized. However, the danger is that such payments might be excessive, or made to the wrong partner. This is a high-risk situation!

The partnership must perform a "what-if" calculation that establishes safe payments to each partner. To establish a safe payment, it is assumed that all remaining assets are disposed of for zero proceeds, and the remaining partners absorb any partner debit balances.

The text example on pages 16-22 of the bonus chapter "Accounting for Partnerships" illustrates this process. Also illustrated is a schedule of safe payment, specifying, in advance, who will be entitled to money as collected. This allows partners to understand their cash flow in advance, and eliminates the need for endless calculations.

1.8 Financial statement presentation

Learning objective

Cash A B C

Balances $ 8,000 $(4,000) $(10,000) $ 6,000

Payment from Chu 6,000 — — (6,000)

$14,000 $(4,000) $(10,000) —

Distribution to Able and Barker (14,000) 4,000 10,000 —

Balances $ — $ — $ — $ —

Cash A B C

Balances $8,000 $(4,000) $(10,000) $(6,000)

Loss on uncollectible amount due from Chu — 3,000 3,000 (6,000)

$8,000 $(1,000) $ (7,000) —

Distribution to Able and Barker (8,000) 1,000 7,000 —

Balances $ — $ — $ — $ —


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� Prepare, in good form, the financial statements for a partnership. (Level 1)

LEVEL 1

The disclosure requirements for unincorporated businesses such as partnerships or sole proprietorships are set out in section 1800 of the CICA Handbook, "Unincorporated Businesses." As in the case of a corporation, the financial statements of a partnership should include a balance sheet, income statement, and cash flow statement. However, a partnership will include a "statement of partners' equity," outlining changes in owners' equity, rather than a statement of retained earnings. This statement must clearly show changes from investment, drawings, and income earned.

The financial statements of a partnership have to include the names of the partners and the name under which the business is operated. In recognition of the fact that partners have unlimited liability and the assets of the partnership are therefore available to the personal creditors of the owners, the CICA Handbook, section 1800.05, requires that appropriate disclosure be made:

It should also be made evident that the business is unincorporated and that the statements do not include all the assets, liabilities, revenues, and expenses of the owners.

This disclosure is an application of the business entity assumption: the business entity is considered an accounting unit separate and apart from its owners. The assumption ignores the legal status of the partnership (not separate and apart from the owners) and the fact that many loans made to a partnership are secured by the partners' personal assets. A lender would likely ask to see a personal net worth statement (list of personal assets and liabilities for each partner) in addition to the partnership financial statements.

The CICA Handbook appears to allow the charging of salaries, interest, and other such items paid to partners against income. Most accountants agree that such items are more appropriately charged against equity because they represent allocations of income to the partners. If salaries and interest are accounted for as charges against income, the CICA Handbook, section 1800.07, requires that they be disclosed separately:

Any salaries, interest or similar items accruing to owners ... should be clearly indicated by showing such items separately either in the body of the income statement or in a note to the financial statements.

If the financial statements do not reflect charges against income for salaries and other items, this fact should also be disclosed.

Because a partnership is not a separate entity for income tax purposes, no provision for income taxes should be made in the financial statements. Disclosure of this fact should be made.

Finally, a statement is required showing the changes in owners' equity, by source, for the period.

Example 1.8-1 shows a sample set of financial statements for a partnership.

Example 1.8-1: Financial statements for a partnership

Dunlaney and Petersen Partnership, Importers Income statement

year ended December 31, 20X8


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Allocated as follows:

Dunlaney and Petersen Partnership, Importers Statement of partners' equity year ended December 31, 20X8

Dunlaney and Petersen Partnership, Importers Balance sheet

December 31, 20X8

Sales $120,000

Cost of goods sold 72,000

Gross margin 48,000

Operating expenses 20,000

Net income $28,000

Dunlaney Petersen Total

Partners' salaries $ 10,000 $ 5,000 $ 15,000

Interest on capital — 2,000 2,000

Remainder equally 5,500 5,500 11,000

Total $15,500 $12,500 $28,000

Dunlaney Petersen Total

Capital — January 1, 20X8 $15,000 $23,000 $38,000

Net income for the year 15,500 12,500 28,000

30,500 35,500 66,000

Drawings (16,500) (13,500) (30,000)

Capital — December 31, 20X8 $14,000 $22,000 $36,000

Assets

Current

Cash $ 8,000

Accounts receivable 15,000

Inventory 24,000

47,000

Capital assets (net) 48,000

Total assets $95,000

Liabilities and partners' equity

Liabilitites


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Dunlaney and Petersen Partnership, Importers Note to the financial statements

December 31, 20X8

The accompanying financial statements include only the assets, liabilities, revenues, and expenses of the partnership carried on under the name of Dunlaney and Petersen Partnership, Importers and do not include the personal assets, liabilities, revenues, and expenses of the partners. No provision for income taxes has been made in these financial statements because income of the business is taxable only in the hands of the partners. No amounts have been charged against income for salaries, interest, or other similar compensation to the partners.

1.9 Ethical accounting policy choice

Learning objective

� Explain the importance of accounting information and policy choice in contracting situations and describe some typical motivations for accounting policy choice (Level 1)

Required reading

� ERH, Unit C3, CGA-Canada's "Code of Ethical Principles and Rules of Conduct" (Level 1) � Reading 1.9-1, "Extract from Canadian Cases in Financial Accounting" (Level 1)

(For all ethics-related readings in this course, it is assumed that you are already familiar with Section A of the Ethics Readings Handbook. ERH readings are accessible through the Resources tab. When you read the Code of Ethical Principles and Rules of Conduct, pay particular attention to sections R100, R200, R300, and R400, to the first statement of ethical principle, Responsibilities to Society — which emphasizes the member's obligation to act with "trustworthiness, integrity and objectivity" — and to rule R101, "Discredit." )

LEVEL 1

As an accountant, you need to be able to choose appropriate financial accounting and reporting policies in a variety of circumstances. This requires the ability to apply the recognition criteria appropriately, and to exercise ethical behaviour when making such decisions.

Consider the general problem of accounting policy choice described in Reading 1.9-1. Then consider some

Current liabilities $ 29,000

Loans payable 30,000

59,000

Partners' equity

Partners' equity 36,000

Total liabilities and partners' equity $95,000


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specific factors that may influence accounting policy choice:

1. Management incentive plans In many large companies, management remuneration packages provide a salary, cash bonuses based on net income, and stock incentives based on share price performance. Common shares are offered to managers based on share price performance to try to align the long-term interests of the firm's shareholders and its managers. The cash bonus is based on a percentage of income once a target is reached. Once net income rises above a certain ceiling, no further bonus is paid. This practice provides a great incentive to keep income between the target and the ceiling. That is, managers of units with income above the ceiling are motivated to pick accounting policies that carry forward 'surplus' earnings to the next period.

2. Lending covenants Long-term lending contracts often include covenants to protect the lender from observable actions by the borrower that are against the lender's interests, such as additional borrowing or excessive dividend payments. Covenants are often based on ratios such as working capital, times interest earned, debt to equity, and so on. Violation of a debt covenant puts the borrower in default of the loan contract; the lender can demand repayment or, more commonly, renegotiate terms and conditions, including interest rate charges. Firms affected by these covenants try to select accounting policies that improve critical ratios.

3. Political motivation Is it possible to report too much income? If a firm is politically visible (usually because of size, the nature of the business, or because of a government-awarded monopoly), high levels of return are potentially undesirable. High profits attract attention and may create enough dissatisfaction and political unrest to cause the government to regulate some aspect of the business or intervene in another fashion. Such firms would rather minimize reported accounting income at levels that provide (barely) satisfactory levels of return to creditors and investors.

4. Taxation Reduction of income to lower tax payments is an obvious motivation for accounting policy choice. Remember, though, that there are extensive provisions in the Income Tax Act requiring the use of certain accounting methods for tax purposes, regardless of the accounting policy choice made for external reporting; thus, firms may have little room to manoeuvre.

5. Contracts Legal agreements often refer to data (numbers) in (audited or unaudited) financial statements. For instance, an agreement may specify that "net income" is to be allocated in a variety of ways or that "book value" of equity (or a multiple thereof) is to be used to establish a buy-out price when a partner retires or a new partner arrives. In these circumstances, there is considerable contractual motivation to manipulate income and book value. How can the contracting parties make sure that manipulation does not lead to inappropriate valuation? Specifying that GAAP must be followed is a first step. However, there are areas of accounting policy where GAAP leaves room for choice. For legal contracts, it is wise to establish explicit accounting policies that govern critical financial statement elements and to allow no changes unless all parties agree. For partnership agreements, it is


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also wise to establish an arbitration process to follow in the event of a dispute, to avoid long, costly, and potentially embarrassing legal actions.

Policy choice and ethical considerations

How do accountants choose accounting policies? First, the accountant must consider the generally accepted accounting principles that govern the firm's specific circumstances. Fair presentation is part of GAAP. In many cases, GAAP offers no leeway and the GAAP-dictated policy is the only choice.

If GAAP allows choice, the accountant must determine which alternative suits financial statement users the best. Before making a recommendation, the accountant must consider not only the "insiders" but all stakeholders. An ethically defensible resolution is not necessarily an ideal or perfect solution, but represents a "good enough" solution. (See Unit A8 in the ERH if you would like to refresh your memory about this decision-making process.)

Accounting policy choice can seem manipulative at times. The accountant must apply a personal and professional code of ethics and understand when to "draw the line."

There are many contemporary stories about business failures accompanied by less-than-appropriate choices of accounting policy. Enron and the like have left permanent scars in the investment community, and have helped to focus attention on the critical and sensitive issue of policy choice.

Differential accounting

Beginning in 2002, differential accounting became part of Canadian GAAP. Differential accounting applies to private (not public) businesses if their owners unanimously consent. Thus, a partnership that is not a public entity can opt for differential accounting if the partners all consent. (A partnership might be a public entity if it has debt that is publicly traded, or if it is in a regulated industry, deemed to affect the public interest.)

What is the big deal? Differential accounting allows simpler accounting policies to be chosen in certain areas with no deviation from GAAP. For partnerships, two main areas are affected:

� Subsidiaries and joint ventures may be accounted for with the cost or equity method, rather than consolidation or proportionate consolidation.

� Significant influence investments may be accounted for using the cost method, rather than the equity method.

These alternate acceptable policies have been determined with reference to the cost/benefit trade-off: The cost of more complicated accounting policies would not be justified by better decisions made by the users.

Note that partnerships may choose appropriate policies in these areas; they are not required to follow the differential rules. The GAAP emphasis is on appropriate choice in the circumstances. Of course, the policy chosen must be disclosed.


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1.9 Ethical accounting policy choice - Content Links

Reading 1.9-1

Extract from Canadian Cases in Financial Accounting

A financial report can be viewed as a method for one group (e.g., a business owner) to communicate with another (e.g., a chartered bank). The person who receives this communication will use it to make decisions (e.g., lend money, change interest rates). If financial accounting is seen as having the power to affect behaviour, it is only natural to expect the preparer to wish to present it in a way that might increase the likelihood of getting the desired behaviour. This is neither good nor bad, it is merely a factual observation. Professional accountants have to understand the potential biases in a situation in order to be effective.

In financial accounting, generally accepted accounting principles (GAAP) exist to establish the basic ground rules. In some instances, they are specific, rule-oriented pronouncements that leave little room for the exercise of professional judgment. For example, the CICA Handbook sections on earnings per share and leases are very specific. In other areas, the standards require that circumstances be carefully considered, and judgment used, when establishing an accounting policy. For example, the accounting policy chosen to translate the statements of a foreign subsidiary into Canadian dollars depends on Handbook-specified individual circumstances. In other areas, a variety of accounting policies are acceptable under GAAP, with few indications of the factors that should dictate choice. For example, inventory costing methods (FIFO, LIFO, weighted average, and the like) and amortization methods (straight line, declining balance, and so on) are not narrowed in any directive manner.

How does a professional accountant make decisions when there is choice? If application of certain policies produces statements that are more suitable for the purpose for which they are intended, then the choice seems obvious. But "suitability" is subjective. The professional accountant must guard against biasing statements to attempt to ensure a given outcome. Fair presentation is an overriding concern.

The value of accounting information is partly a function of reliability, of which a major component is neutrality. Accounting information would soon lose its credibility if it were biased or expected to be biased.

Think of the role of the professional accountant like this: First, to understand the environment, circumstances, and motivations of the providers (and users) of accounting information who produce (or use) an accounting policy or a desired policy. Second, to judge the acceptability of a policy in relation to established standards, a combination of technical knowledge and judgment. Usually, the standards are GAAP and fair presentation, but in some cases all parties are better served by tailor-made policies. Third, the accountant must have the ability to implement the policy — the application of technical knowledge.

Source: Carol Dilworth and Joan Conrod, Canadian Cases in Financial Accounting, Second Edition (Homewood, Illinois: Richard D. Irwin, Inc., 1993), page 1.

1.10 Introduction to case analysis

Learning objective


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� Perform a simple case analysis: recognize the problem, identify and analyze policy choice alternatives, and provide an ethical recommendation. (Level 1)

Required reading

� Analyze a case (under the How to tab) (Level 1)

LEVEL 1

One of the most important skills for a professional accountant is the ability to analyze a financial accounting situation, identify alternatives, and formulate recommendations using ethical, professional judgment. In this topic, you explore case analysis by writing your own response to a case and comparing it to the suggested solution and to a sample student response. Before you begin, you should review the required reading, and the case analysis section of the Introduction to FA3, particularly Preparing a case analysis report. The marking key in the solution to Activity 1.10-1 will help you understand the expectations for case analysis.

Test your ethics and practise performing a case analysis by reading the case scenario in Activity 1.10-1 and working through an analysis to formulate an appropriate response. (Take the time to write an appropriate response before reading the suggested solution. By doing so, you will learn more from this exercise.)

Activity 1.10-1: Sample case analysis — Chan and Baaz

Sandy Chan and Philip Baaz have operated an import and sales partnership for 15 years. They import a variety of food products into Canada and distribute them to small specialty grocery stores and some larger chain stores in southern Ontario. At times, they have made profits of up to $150,000 per year (profits and losses are split equally); however, the lingering recession has hurt their business and profits were only $80,000 last year. Philip Baaz, in his late 50s and financially secure, has decided to retire. Tired of Canadian winters, he has retired to Mexico and left the partnership in Sandy Chan's hands.

Sandy Chan is in his mid-40s, and through a series of personal tribulations, is nowhere near as financially secure as his partner. He does not have the resources to buy out Baaz personally, and there is no cash in the partnership at the moment. Assets consist of receivables and inventory. A significant downsizing would be required to buy out Baaz with a payment from the partnership right now. Baaz, however, is in no hurry for his money. The partners have agreed that for the rest of this year, Chan will operate the business alone, and profits will be split evenly. At year end, Baaz will leave the partnership and take back a five year note payable for the book value of the balance in his partnership account, which would include his share of current year profits. While Baaz would not have helped generate this year's profits, this allocation was agreed to be fair due to his past contributions.

At the end of the year, you have arrived to prepare the financial statements for the year. You are a professional accountant. The partnership has been your client for 15 years (since the partnership was formed), and you are on excellent terms with the partners and their staff. You have met with the bookkeeper and obtained the following information:

1. Since Chan and Baaz have personal contact with their customers, the partnership has always established an allowance for doubtful accounts based on specific identification of problem accounts. This year, the allowance has been based on a percentage of sales — at a rate that is double the historical trend. The bookkeeper has assured you that most receivables are current, but "there's a recession on and we expect some problems to crop up."


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2. During the year, a sizeable amount of inventory acquired during the last two years was written off. The bookkeeper explained that the product was not perishable, that it was still in the warehouse but very slow moving, and that Chan had given up trying to sell it.

3. A personal computer and laser printer were acquired for office use late in the year. Consistent with prior policy, a full year's amortization was booked in the year of acquisition. Previous office equipment has been amortized using the straight-line method, but the computer is being amortized on a 40% declining balance scheme "because of the risk of technological obsolescence."

You have a meeting scheduled with Chan this afternoon to discuss accounting policies and operating results; Baaz is still in Mexico.

Required

Write a brief report on which to base your discussion with Chan. Outline the issues and alternatives, then write an analysis of each issue and your recommendation. Write a separate note that states your likely course of action should Chan not accept your recommendations.

As you consider this scenario, ask yourself the following questions:

1. How do the two partners' motives differ in this situation?

2. Whose interests are you protecting?

3. If you anger Chan, will you lose a client? Should this be your primary — or secondary — motivation?

4. What are the accounting issues?

5. For each issue, is the accounting policy chosen acceptable?

� Under what circumstances would it be acceptable? � What extra information would you like to have? � Are Chan's concerns legitimate? How can you fix the problem? � What do you recommend?

6. What are you going to do if Chan doesn't like your recommendations?

� Disclose policies in the notes? � Contact Baaz? � Resign? � Attempt to arbitrate the problem?

Solution

1.10 Introduction to case analysis - Content Links


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Activity 1.10-1: Suggested case analysis solution

Take a look at the suggested solution and the sample student response. Then try to mark your own response using the key provided following the solution.

Overview

The Chan and Baaz partnership is in the import and sales business and is less profitable now than in the past. It is in its last year and will become Chan's sole proprietorship next year. Baaz is entitled to half the current year's profits and his book equity value at the end of the year. Chan has an obvious incentive to minimize income and net assets in these circumstances. Baaz would be interested in fair evaluation of operating performance and net assets, and in ensuring that the entity remains viable, since he is not entitled to a payout for five years.

Issues

The partnership has new/questionable policies for

1. Allowance for doubtful accounts: percentage of sales versus specific identification 2. Write-off of obsolete inventory 3. Amortization policy for new computer equipment

Analysis

1. Allowance for doubtful accounts An allowance for doubtful accounts must be established, but several approaches to establishing the appropriate amount are allowed under GAAP. In the past, specific identification has worked well, but percentage of sales is objective and also acceptable. It is a concern that the percentage chosen for this year is double the historical experience and that there is no evidence to support the need for a larger allowance. Vague worries about the recession cannot be allowed to cause a larger expense and lower assets. Chan should be asked to prepare an estimate of doubtful accounts based on the same criteria as prior years, and the allowance should be adjusted accordingly. On the other hand, Chan, the continuing owner, may have a valid concern in this area. He has to pay his partner for his interest in these receivables; what if they are never collected? Chan must bear all the risk. The buy-out agreement could be amended to specify that the book value of Baaz's equity be adjusted for any uncollected receivables in excess of the allowance. Fortunately, the five-year lag would easily accommodate this adjustment, as all receivables would be settled — or written off — over this time.

2. Inventory Is the inventory really obsolete? Assets with no objectively verifiable future cash flow have to be written off to current income, and Chan has given up trying to sell this slow-moving inventory. On the other hand, it is not perishable, and it is still in the warehouse. A future sale is therefore possible. It would be wise to review the sales history for this product and do some independent investigating into the existence of a sales market. Baaz should be consulted to see if he feels this product is worthless. Again, the impression is that Chan is trying to decrease income and net assets to reduce the buy-out


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price. If the inventory is a major motivating factor, the buy-out agreement could be renegotiated to allow for reduction of the price if the inventory doesn't move over the next five years. The proper accounting policy — write off or not — depends on the result of further investigation and discussion with Chan and Baaz. On a cautionary note, it is not clear that Chan will suffer, even if some receivables and inventory are worthless. First, some inventory would be worth more than the book value paid to Baaz. Chan may have to accept assets with market values below book value (the "bad") in order to get assets with market value above book value (the "good"). Second, a payout of book value does not allow for goodwill that the partnership has established. Chan may therefore be getting a reasonably good deal. (Keep in mind, though, that this outcome is hard to assess and income is down.)

3. Amortization policy The accounting policy for amortization of computer equipment has resulted in 40% of the capital cost of the asset being written off this year, although the asset has only been owned for a few months. The current year had little benefit from the equipment. Is it realistic to write off most of such an asset over less than three years? Does this company need leading-edge technology or is it likely to be able to use this equipment for five to seven years? Chan should estimate the likely useful life of the equipment and retain the policy of straight-line amortization over the life of the asset. Since the firm has in the past recorded a full year of amortization in the year of acquisition, this policy is marginally acceptable. Prorating by month would be more appropriate in these circumstances. However, if the amount is not material now that straight-line amortization is used, and if Baaz is aware of the situation, the policy is permissible.

Recommendation

The allowance for doubtful accounts should be based on specific identification, as in prior years. Inventory obsolescence should be investigated further and discussed with both partners before a write down is taken. Computer equipment should be amortized on a straight-line basis over its useful life. The policy relating to amortization in the first year of ownership should be re-evaluated and agreed on by the partners.

The buy-out agreement between Chan and Baaz should be re-evaluated to adjust for uncollectible accounts and obsolete inventory.

Note on ethics

As the accountant of the partnership, I have been hired by both partners and owe a duty to both.

A meeting or a conference call between Chan, Baaz, and myself should be planned to discuss operating results, accounting policies, and the buy-out agreement.

If Chan is not in agreement with my analysis and recommendations, Baaz should be contacted directly to make him aware that his interests are being affected. I may have to assist in the renegotiation of the buy-out agreement or arrange for an outside arbitrator if the two parties are in conflict.

Marking key


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Note: In the marking key that follows, bulleted items are worth the point value shown in brackets. The available points often add up to more than the maximum points indicated to allow for alternative valid approaches to a given situation. Maximum marks per section, or for the case as a whole, cannot be exceeded.

Overview

� Partner buy-out based on book value for accounting (1) � Chan has incentive and power to minimize assets and income (1) � Baaz served by "fair" evaluation; needs operation to thrive to get money (1)

Maximum 2

Issues

Accounting policies for

� Estimation of allowance for bad debts � Write-off of obsolete inventory � Amortization policy for computer equipment (1 mark for list)

Maximum 1

Analysis

Doubtful accounts:

� Allowance required under GAAP but approach is subject to professional judgment (1) � Describe prior practice (1) � Percentage chosen this year is double the historical rate (2) � Concerns about recession vague (1) � Ethical concern that Chan is overestimating (1) � Ethical concern that Chan would be stuck with bad accounts in the future (that is, Baaz is treated too

well in current deal) (1) � Other valid points (1 each, maximum 3)

Inventory:

� Inventory must be written off if it cannot be sold (1) � This inventory may not be obsolete: not perishable, still in warehouse (2) � Need to review evidence to suggest presence of market, etc. (2) � Ask Baaz his opinion (1) � Ethical concerns: effect on Chan; effect on Baaz (1 or 2) � Other valid points (1 each, maximum 2)

Amortization policy:

� Policy chosen is aggressive; decreases income (1) � Asset only owned for a few months this year; little benefit (1) � Effective amortization period very short; does it represent the period of use? (1) � Ethical concerns: effect on Chan; effect on Baaz (1 or 2)


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� Discuss part-year amortization (1) � Other valid points (1 each, maximum 2)

Maximum 13

Recommendation

A sensible recommendation, consistent with analysis

0 for no recommendations or illogical recommendations 1 for a weak recommendation 2 for intelligent, logical recommendations

Maximum 2

Communication

Organization, quality of expression

0 for unacceptable communication skills 1 for weak communication skills 2 for acceptable communication skills

Maximum 2

Overall — maximum 20

Note: There is no right answer to a case; marks are awarded for valid analysis and consistent recommendation. The marking key is provided for guidance. You are not expected to cover all the points.

An unsatisfactory response

Read and evaluate the following (unsatisfactory) student response.

Overview

Chan is in a position where he can manipulate the financial position of the partnership for his own benefit, and has chosen accounting policies that understate income and assets. This is not appropriate.

To begin a case well, you should identify the major users of the financial statements and the earnings or disclosure pattern the entity is likely to adopt. The student should identify the presence of the buy-out agreement and explain how to serve Baaz's interests.

Marks granted for overview: 1

Issues


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The accounting issues are accounting for obsolete inventory, accounting for the allowance for doubtful accounts, and amortization methods.

The issues were clear in the case…hard to miss! The student simply itemized the issues here, with no explanation. This is appropriate.

Marks granted for issues: 1

Analysis Allowance for doubtful accounts

Chan is again trying to rip off his partner by understating the value of the accounts receivable. The allowance should be based on past experience.

Use of slang ("rip off" ) is never acceptable in a written assignment. Keep the language formal. Second, remember to whom this report is going — do you think Chan will appreciate this remark? Policy choice is about objectivity, and this student has obviously taken a side. More effort should be invested in an even-handed analysis. Again, there is no analysis, just a recommendation. You have to communicate your thought process, not just the "bottom line."

Obsolete inventory

Obviously inventory isn't an asset if it can't be sold, and Chan looks as though he is on solid ground. However, if he later "tried harder" and sold this inventory, he'd have a lot to gain and Baaz would have been cheated. Therefore, it's important to look at evidence that the inventory is really obsolete. Chan is likely wrong here, and the inventory should not be written off.

Off to a good start…the student explains why the write down is needed, and also explains how the users would be affected by the write down. The recommendation is hasty, though — what evidence would you look for to suggest either writing off or leaving the asset intact?

It's quite acceptable to include recommendations at the end of the relevant analysis. They can also be put in a separate section at the end.

Amortization policy

Chan is incorrect in changing amortization methods simply to further his own interests. The amortization policy of past years should be applied this year.

Is this an analysis or just a conclusion? It's important to provide analysis before providing the recommendation. Explain the effect of the decision on the financial statements — that income is down as a result, and a major portion of the asset written off in the first year, and over the first three years. Then ask if this is a good way to measure the value received. If Baaz is served by "fair" accounting policies, try to explain what "fair" would be in these circumstances.

Why weren't the issues dealt with in the order that they were listed in the issues section?

Marks granted for analysis: 1 + 3 + 0 = 4

Marks granted for communication: 2 (The report's grammar is acceptable.)


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OVERALL MARK: 8

Module 1 self-test

Question 1

Computer question

Ng and Foran began a partnership by investing $136,000 and $204,000, respectively. During the first year of operation, the partnership earned $90,000. Each partner withdrew $2,000 per month from the partnership.

Required

Part a

Establish the distribution of profits for the partners including the percentage of total partnership profit, assuming each of the four separate scenarios below:

1. There is no established agreement for sharing income.

2. The partners agree to share income by allocating a salary of $40,000 to Ng, $20,000 to Foran, and the residual is split 2:1.

3. The partners agree to share income by allocating a salary of $25,000 to Ng, $15,000 to Foran, interest of 5% on opening partner balances, and the residual split in proportion to opening partner capital balances.

4. The partners agree to share income by allocating a salary of $65,000 to Ng, $60,000 to Foran, interest of 5% on opening partner balances, and the residual split in proportion to opening partner capital balances.

Part b

Prepare a statement of partners’ capital for Year 1, assuming distribution of income as in part a, step 4.

Note: Before you start this question, you should work through the computer activity in Topic 1.5. For an


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example of a statement of partner’s capital, as required in part (b), see page 4 of Hilton’s "Accounting for Partnerships."

Procedure

1. Start Excel and open the file FA3M1Q1. This file can be found in the DATA subfolder where you installed the course. (Before you begin working on the data files in this course, you must first download them and save them to your hard drive. Click the data files link in the navigation pane, then follow the instructions for downloading and saving the files.)

2. Click the sheet tab for M1Q1A1 (or M1Q1A2, M1Q1A3, M1Q1A4 as required).

3. Observe that rows 8 to 24 contain the data table. The schedule of partnership profit distribution starts in row 26. This schedule is blank except for column and row labels.

4. Enter the appropriate formulas in rows 33 to 35.

5. Enter the necessary formulas in row 37, using a cross-adding IF statement as a further test of accuracy in cell G37. (The sum of cells B37 to D37 should equal the sum of cells G33 to G35. If they don’t, Excel should display an error function as a result of the IF statement.)

6. Enter the required formulas in row 39 to calculate the percentage of total partnership profit distributed to each partner.

7. Save a copy of your completed worksheet.

8. Repeat steps 2 to 7 for each of scenarios 2 to 4.

Solution

Question 2

Computer question

Problem 10, page 31 of "Accounting for Partnerships"

Note: Ignore the requirement in the problem and answer the requirement listed below.

Required

Using the data in parts a and b of Problem 10, prepare a partnership liquidation schedule that shows the February and March activities. Assume that cash is distributed only at the end of March.

Procedure

1. Start Excel and open file FA3M1Q2.


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2. Observe that rows 7 to 32 contain the data table. The schedule of liquidation starts in row 36. This

schedule is blank except for column and row labels.

3. Enter the profit and loss ratios in row 43, using cell references to the data table. Enter the appropriate cell references in row 45 to set up the pre-liquidation balances.

4. Rows 46 and 50 require formulas to pick up the asset liquidation transactions from the data table. Enter these formulas.

5. Rows 48 and 54 should contain subtotals of the previous transactions. These rows will contain the updated balances in the accounts when the appropriate formulas have been entered.

6. Enter formulas in rows 47, 51, 52, and 53 to reflect payments made to creditors (whether the liability was previously recorded or not). Liabilities/payments not previously recorded will affect the capital accounts.

7. Complete the formula in row 55 to distribute the final cash to the partners.

8. Row 57 will contain the post-liquidation balances if you have entered the correct formulas.

9. When all the formulas have been entered correctly, save the file.

Solution

Question 3

Multiple choice

a. If the proprietary view of an organization is followed, which of the following statements is true?

1. The accounting equation is viewed as Assets = total equities (liabilities + equity). 2. The income statement has a focus on operating income before distributions to a variety of

stakeholders. 3. All groups except owners are viewed as outsiders, and all charges to outsiders are on the income

statement. 4. The entity is considered to have a separate existence apart from all groups of stakeholders.

b. Which of the following statements is true with respect to the mutual agency relationship of a regular

(that is, not a limited) partnership?

1. Mutual agency exists unless the partnership agreement states otherwise. 2. Partners can commit each other in contracts to third parties. 3. Contracts with third parties must be ratified by partners before they are legally enforceable. 4. Partners have unlimited personal liability.

c. Why would a partnership with annual net income of $10,000 consider incorporation?

1. Reduce income tax on annual income 2. Allow business losses to be deducted from other income of the partners 3. Reduce requirements of government regulation and annual reporting 4. Limit personal liability


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d. Which of the following is not a reporting requirement for unincorporated businesses, as set out in the

CICA Handbook?

1. A balance sheet, income statement, and cash flow statement 2. An indication that the entity is unincorporated and that the statements do not include all the

assets, liabilities, revenues, and expenses of the owners 3. A net worth statement 4. A statement showing the changes in owners’ equity, by source, for the period

e. An entity chooses to record the value of stock options granted to employees as an expense on the

income statement, instead of the more common disclosure alternative. This policy lowers net income and retained earnings, but results in higher common share values. The expense is not tax-deductible, according to the provisions of the Income Tax Act. What would be the most likely motivation of this company?

1. It has a covenant on net income (net income must be at least a certain level) in a lending arrangement or interest charged will increase; the entity is concerned that net income remain healthy.

2. It is motivated by political pressures. 3. It has a covenant on the current ratio (current assets divided by current liabilities) in a lending

arrangement and is concerned that the current ratio remain healthy. 4. It is trying to minimize income tax.

f. Which of the following relates to "differential accounting"?

1. Partnerships do not expense salaries and interest on partner capital balances. 2. Simpler accounting policies can be chosen in certain specific areas with no deviation from

GAAP. 3. Partnerships are not allowed to use the equity method to account for significant influence

investments. 4. Partner’s withdrawals are accounted for in a manner similar to dividends, when comparing a

partnership to a corporation.

Solution

Question 4

Problem 7, pages 28-29 of "Accounting for Partnerships"

Note: There should be two alternatives presented for proposal A and one alternative method for proposal B. The approach to proposal B should be based on the norm in practice (see Topic 1.6). Allocations are based on Burnham’s share of capital (20%), not profits (25%).

Solution

Question 5


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Shiraf, Fraser, and Simone are partners; their capital balances and profit and loss ratios are as follows:

Fraser retires and receives a cash payment.

Required

Provide two alternative journal entries (for each case — a total of four entries) to record Fraser’s retirement assuming that:

Case 1. Fraser is paid $400,000 Case 2. Fraser is paid $295,000

Solution

Question 6

Case analysis

Tan and Therson (Tan) is a partnership of lawyers. It was recently formed through a merger of two predecessor partnerships: Tan and Harris (TH) and Therson and Smith (TS). The merged firm has 38 partners, six from TH and 32 from TS, and a total of 75 employees. On the date of the merger, Tan purchased land and an office building for $1.25 million, and fully computerized their new office. The partners have decided that the financial statements of Tan will be audited annually, although neither of the predecessor firms was audited.

Tan has arranged a line of credit with a bank that allows the partnership to borrow up to 75% of the carrying value of receivables and 40% of the carrying value of work in progress recorded in the monthly (unaudited) financial statements. This same bank provided loan financing of $750,000 for the land and building. The bank requires audited annual financial statements.

The partners have been actively engaged in establishing and managing the practice and have paid little attention to accounting policies.

The partnership agreement requires an annual valuation of the assets and liabilities of the firm at current replacement cost. This valuation is to be used to determine the payment made by the firm to a withdrawing partner and the contribution to be made to the partnership by a newly admitted partner. The partners are unsure of the accounting implications of this requirement. Current replacement costs could be recorded in the books each year, or just acknowledged in a separate report.

Before the merger, TH recorded revenue when it received payment from the client. Time reports were used to keep track of the number of hours worked for each client, although this information was not recorded in the accounting system. When a bill was sent, the account receivable would be recognized, but revenue was deferred until collection. In general, accounting records were not well maintained.

In contrast, work in progress was recorded for employees of TS at their regular billing rate, on a client-by-client basis, based on the hours worked, even though the full amount was not always recoverable. When clients were billed, work in progress was reduced and accounts receivable was increased. When bills were

Shiraf $256,000 .6

Fraser 344,000 .2

Simone 126,000 .2


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issued, and at year end, an adjustment was made to write off any amount in work in progress that was uncollectible. Thus, revenue was recognized as work was done, subject to the valuation adjustment.

In both firms, collection of client accounts was slow. That is, a client might not pay a bill for up to a year after it was presented. The partners have made serious efforts to improve collection experience since forming Tan, but the average age of accounts receivable is still six to eight months.

Each partner receives a maximum monthly withdrawal payment, which represents an advance on the partner’s share of profits. Profits are split on the following formula:

1. First, interest of 5% on the opening capital balances

2. Remaining profit, after "interest", is allocated on the relative number of billable hours logged by each partner. Both the total billable hours and each partner’s billable hours are reduced for time spent that cannot be recovered from clients. That is, assume that Partner 14 recorded 3,000 billable hours during a year, of which 450 were considered unbillable. Partner 14 would be acknowledged as having 2,550 hours in the formula.

Partners are permitted to withdraw, in cash, up to 80% of income allocated to them within 30 days of the year end. For example, if Partner 14 was allocated $78,000 of income, and had withdrawn $50,000 during the year, the partner would be allowed $62,400 ($78,000 × .8 = $62,400) for the year and an additional year-end withdrawal of $12,400 ($62,400 – $50,000). This equity may be left invested in the partnership, but most, if not all, partners are expected to take the maximum withdrawals. The remaining 20% of profits must be left in the partnership.

Your firm has been engaged by Tan to prepare a report advising the partnership on financial accounting issues. You realize that asset valuation (historical cost versus current replacement cost) and revenue recognition are critical choices of accounting policy.

Required

Prepare the report.

Source: Based on Case 4-3, Smith and Stewart, in Beechy, T.H., and Conrod, J.E.D. Intermediate Financial Accounting, Volume 1, Second edition, (Toronto: McGraw Hill, 2002), pages 168-169. Used with permission.

Note: Case analysis is limited to 1,000 words.

Solution

Self-test - Content Links


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Self-test 1

Question 1: Computer solution

Part a

Step 1

Step 2

Step 3


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Step 4

Computer formulas

Note: the formula in cell G35 could be = SUM (B35: D35).

Part b

Ng and Foran Partnership Statement of Partner’s Capital

For the year ended Dec 31, Year 1

Ng Foran Total

Opening investment $136,000 $204,000 $340,000


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Self-test 1

Question 2: Computer solution

Self-test 1

Question 3 solution

a. 3) In the proprietary view, charges to outsiders — interest, tax, wages — are expenses, so item 3 is correct. All other items describe the entity view.

b. 2) Mutual agency allows one partner to contract on behalf of all partners; item 2 is correct. Mutual agency cannot be eliminated in the partnership agreement, so item 1 is incorrect; contracts do not have to be ratified, so item 3 is incorrect; and personal liability is not a feature of mutual agency, so item 4 is incorrect.

c. 4) The corporate form will limit personal liability. Item 1 is incorrect because at low levels of income, a corporation will have higher income tax rates. Business losses can be deducted from other employment income only if the entity is a partnership, so item 2 is incorrect, and corporations have higher regulation and reporting requirements, so item 3 is incorrect.

Add net income 51,000 39,000 90,000

187,000 243,000 430,000

Deduct drawings 24,000 24,000 48,000

Balance, end of year $163,000 $219,000 $382,000


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d. 3) A net worth statement is not part of the reporting requirements of an unincorporated entity; all other items are required.

e. 2) Expensing stock options will reduce net income, and reduce the apparent profitability of the corporation; this may help avoid political attention. Item 1 is incorrect because income is reduced by the choice of policy, item 3 is incorrect because the policy will not change the current ratio, and item 4 is incorrect because the question states that the expense is not tax deductible.

f. 2) Item 2 is the definition of differential accounting; item 1 and item 4 are correct statements but not related to differential accounting. Item 3 is incorrect because the equity method may be used if the partnership wishes.

Self-test 1

Question 4 solution

Proposal A:

Alternative 1:

Cash 45,000

Asset 25,000

Burnham, capital [20% of ($200,000 + $70,000)] 54,000

Smith, capital (50% of $16,000) 8,000

Jones, capital (30% of $16,000) 4,800

Fleesum, capital (20% of $16,000) 3,200

Alternative 2:

Asset (or Goodwill) 80,000

Smith, capital (50% of $80,000) 40,000

Jones, capital (30% of $80,000) 24,000


$70,000 ÷ 0.2 = $350,000; actual assets are ($200,000 + $70,000)

$350,000 – $270,000 = $80,000

Cash 45,000

Asset 25,000

Burnham, capital 70,000

Proposal B:

Transfer 20% from each partner’s account; no new assets in the partnership.

Smith, capital (20% of $85,000) 17,000


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Self-test 1

Question 5 solution

Jones, capital (20% of $65,000) 13,000


Burnham, capital 40,000

Case 1:

Fraser is paid $400,000:

Alternative 1:

Fraser, capital 344,000

Shiraf, capital [(0.6 ÷ 0.80) × $56,000] 42,000

Simone, capital [(0.2 ÷ 0.80) × $56,000] 14,000

Cash 400,000

Alternative 2:

Goodwill 280,000

Shiraf, capital (0.6) 168,000

Fraser, capital (0.2) 56,000

Simone, capital (0.2) 56,000

Fraser’s account must be credited for $56,000 ($400,000 – $344,000)

This represents 20% of goodwill of $280,000 ($56,000 ÷ 0.2)


Cash 400,000

Case 2:

Fraser is paid $295,000:

Alternative 1:


Shiraf, capital [(0.6 ÷ 0.80) × $49,000] 36,750

Simone, capital [(0.2 ÷ 0.80) × $49,000] 12,250

Cash 295,000


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Self-test 1

Question 6: Case analysis solution

To: Partners, Tan and Therson

Overview

The major users of the financial statements and their needs are

� The bank. The bank will use the financial statements in assessing Tan’s future cash flows to determine whether these amounts are likely to be sufficient to repay interest and principal amounts to the bank. In addition, the bank will look to the balance sheet to confirm that any loans advanced to Tan are within the agreed limits, namely, 75% of the carrying value of receivables and 40% of the carrying value of work in progress.

� Partners. Partners will use the financial statements primarily to assess the firm’s performance. The partnership also needs financial statements to serve as the "annual valuation." In addition, the partnership will want the financial statements to be prepared in such a way that will maximize loans from the bank. Finally, partners will use the statements to determine the income amounts to be included in their individual tax returns. There is an ethical responsibility to make sure that the financial statements are appropriate for their intended uses: to faithfully represent security for debt without overstatement (unfair to the bank) or understatement (unfair to the partners). Tax minimization is perfectly ethical within the framework of rules provided by the Income Tax Act: this is tax planning, not tax avoidance. Finally, the partners will want to deal ethically with one another as they retire or withdraw, as they will all be there at some time.

Issues

Alternative 2:

Shiraf, capital (0.6) 147,000

Fraser, capital (0.2) 49,000

Simone, capital (0.2) 49,000

Assets 245,000

Fraser’s account must be debited for $49,000 ($295,000 – $344,000)

This represents 20% of asset impairment of $245,000 ($49,000 ÷ 0.2)


Cash 295,000


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1. Asset valuation 2. Revenue recognition

Analysis and recommendations

1. Asset valuation The partnership agreement requires an annual valuation of the firm’s assets and liabilities. The annual valuation is to be used in determining payments to be made by the firm to retiring or withdrawing partners and contributions to be made to the firm by new partners. It is not clear what form the partnership intends the annual valuation to take. Financial statements could be prepared using current replacement costs (instead of historic cost). Or, financial statements using historic-cost values plus a separate, annual valuation report could be prepared. Although the use of current values is generally not in accordance with generally accepted accounting principles (GAAP), Tan’s financial statements do not have to conform to GAAP. What matters is whether the historic cost values prescribed by GAAP or some other basis of valuation will be the most useful to the users of Tan’s financial statements. However, if current costs are used, the financial statements will not be in accordance with GAAP. This may disturb the banker, who is providing significant financial support for the partnership. The partners will obtain all the information they need with a supplementary report. We recommend valuing net assets at historic cost in the primary financial statements, accompanied by a special report on current value to be used for valuation purposes. (Alternatively, current cost information could be suggested and supported, noting that this would trigger a qualified audit report.)

2. Revenue recognition Tan has three options for timing the recognition of revenue:

1. Record revenue as work proceeds. Under this option, all WIP will be recorded at regular billing rates. The asset balance will increase as early as possible, thereby maximizing the limits established on the bank loan as early as possible. However, the actual amount billed to the client may be more or less than the total hours spent on the client’s work. If the discrepancies are material, the usefulness and credibility of the financial statements will be very limited, since revenues for prior periods will constantly have to be adjusted to reflect actual revenues. To the extent that the likely realizable value can be accurately estimated, based on past experience perhaps, then these adjustments may not be material. However, there may be no accurate way to predict unbillable time prior to actually preparing the bill on completion of the job. A lack of accuracy in the monthly statements will harm the partnership, as the bankers rely on these statements and will be concerned if the statements do not provide reliable measures for loan limits. This alternative represents the prior practice of TH and TH partners will be familiar with these practices. If revenue is recognized early, it would be allocated to partners at year end, and 80% would be available for withdrawals. Thus, early revenue recognition, perhaps before collection, would put strains on the cash flow of the partnership. Collection experience is improving, but is still 6 to 8 months.


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2. Record revenue when the amount has been collected. Under this option, revenue will be recognized when the actual collectible amount has been received. Therefore, there will be no subsequent adjustments to the income statement, as may occur under option 1. Accounts receivable will be recorded when amounts are billed, and still serve as collateral, and WIP would be recorded at cost. Revenue would be recorded only when cash is eventually received. However, this option unduly delays the recognition of revenue. It is very conservative, unless there are doubts about the collectability of accounts. While collection is slow, there were no concerns raised about ultimate collection. This alternative will cause no cash flow problems for the partnership, but it will be onerous for the partners, who will receive their share of profits later. On the other hand, it provides a great incentive to speed collection. This method also provides a highly conservative (that is, low) WIP balance for loan collateral, reducing the funds available to the partnership. This is the most cautious alternative.

3. Record revenue when the amount is billed to the customer. Under this option, revenue is recognized when the job is complete. This is more typical revenue recognition — analogous to delivery of goods. At this point, there is certainty about the billable amount compared to the time invested. Reliability of the financial statements is enhanced over option 1. Accounts receivable will be recorded when amounts are billed, and still serve as collateral, and WIP would be recorded at cost. The partnership still runs the risk of recognizing revenue before collection in that some profit will have to be distributed to the partners before collection. Bank financing may be adequate to provide for this cash flow. Cash budgets should be prepared to analyze the adequacy of cash resources. While the partners may well prefer early revenue recognition in alternative 1, it may not be possible to estimate eventual billings. Estimation errors in the financial statements would reduce their credibility, and monthly statements must be credible for the banker. Early revenue recognition would put cash flow pressures on the partnership, because of the arrangement for profit distribution. Alternative 3 is recommended as typical for revenue patterns; it recognizes revenue when earned. If it is not possible because of poor cash flow projections, then alternative 2 must be considered, although it involves very delayed revenue recognition. Obviously, faster collection is a concern for the partners.

Module 1 summary

Partnership equity accounting

This module reviews the basic legal structure of a partnership and covers various accounting issues, such as partnership formation, dissolution, profit distributions, and admission or retirement of a partner. Computer activities cover the distribution of partnership income and liquidation using a spreadsheet program. The module concludes with a discussion of ethical accounting policy choice and an introduction to case analysis.

Accounting policy choice can be motivated by management incentive plans, the presence of lending covenants, political motivations, or taxation. Compliance with GAAP involves many choices and judgments that may be slanted, appropriately or inappropriately. The accountant has serious ethical responsibilities in


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this environment.

You will find a summary of key points on pages 22-23 of "Accounting for Partnerships."

Describe the conceptual nature of ownership interests.

Ownership interests can be classified according to two viewpoints:

1. The proprietary view: � Firm and owners are one and the same � Creditors are outsiders � Narrow view of the firm

2. The entity view:

� Firm is separate entity � Multiple stakeholders:

� shareholders � creditors � government � society

� Broad view of the firm

Explain the rights and obligations of a partner and the concept of mutual agency.

� The rights and obligations of a partner are determined by the relevant provincial Partnership Act, but can be altered by a partnership agreement.

� The basic rights of a partner are � to share equally in the capital and profits of the business � to be reimbursed for business expenses � to receive interest on excess contributions ("advances") � to contribute to the management of the partnership � to consent to the admission of new partners

These rights can be specifically changed by a partnership agreement.

� Partners' obligations arise from the mutual agency relationship that partners have to each partner and to the firm.

� Agency is a legal relationship wherein one person (the agent) represents another (the principal) and can enter into contracts on behalf of the principal with third parties.

� Partners' obligations include � Joint liability for the debts and obligations of the firm; partnership creditors can look to the

personal assets of any of the partners to satisfy their claims. � Liability for the negligence, torts, and breaches of trust of their partners.

Explain how a partnership is created and dissolved.

� Partnerships are created voluntarily by the actions of two or more individuals (or corporations). The business typically begins with an initial investment.


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� Partnerships can be dissolved voluntarily or through legal requirement caused by the death, mental incapacity, bankruptcy, or insolvency of a partner.

Compare and contrast the elements of a general partnership and a limited partnership.

� A limited partnership has one or more general partners, with unlimited personal liability, and one or more limited partners, whose liabilities are limited to their investment. These limited partnerships are often used to structure tax advantages for the limited partners.

Account for the creation of a partnership and its ongoing operations, including the distribution of net income (loss) among the partners.

� When a partnership is created, capital accounts are set up to record contributions, drawing accounts are set up to record periodic withdrawals, and, if necessary, loan accounts are used to record repayable advances. Net income (loss) from ongoing operations is credited (debited) to the partners' capital accounts.

� Profit allocations may be based on � specified ratios � "interest" plus "salary"; residual allocated by a specified ratio

Account for admission, retirement, and withdrawal or death of a partner.

� A new partner can be admitted two ways:

1. Admission through purchase of interest of existing (old) partner Method A: transfer book value Method B: recognize goodwill, then transfer book value

2. Admission through payment to the partnership Bonus method: Old partner's equity accounts are increased or decreased Asset revaluation method: Price paid used to adjust assets

� Retirement or withdrawal of a partner can be at, above, or below book value, and can be based on: � goodwill recognition (not recommended) � bonus

� Partnerships automatically dissolve on the death of a partner. The partnership agreement can provide for continuity.

Account for the liquidation of a partnership.

� A liquidation schedule shows � the realization of assets and the corresponding allocation of gains or losses to the partners � payment of creditors before making any distributions to the partners � settlement of partners' loans and then capital deficiencies � lastly, settlement of partners' balances

Prepare the financial statement for a partnership.


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� The major structural differences between corporate and partnership financial statements are income taxes and the disposition of the "salary" paid to the owner/partner.

� No provision should be made for income taxes as these are the personal liabilities of the partners.

� Salaries to the partners, if presented, should be disclosed separately; otherwise, the fact that no salaries have been charged should be disclosed in the notes.

� The statement of partners' equity should set out the details of each partner's capital contributions, drawings, and net income or loss for the period.

� Disclosure of the nature of the partnership organization is an integral part of partnership financial statements.

Explain the importance of information and policy choice in contracting situations and describe some typical indications for accounting policy choice.

� Accounting policy choice is important when financial statement data are used in contracts. While this issue is important for corporations, the use of the partnership financial statements in distribution of net income (loss), in buy-outs, and in establishing capital entitlements makes policy choice for partnerships particularly critical.

� Accounting policies must be perceived to be fair to all contracting parties.

� When making accounting policy choices, an accountant considers � GAAP � fair presentation � the firm's specific circumstances � the needs of the financial statement users

� Accounting policy choice may be influenced by such factors as management incentive plans, lending covenants, political motivations, taxation, and contracts.

Perform a simple case analysis.


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