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Principles of Accounting, Volume 1: Financial Accounting

15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries

Principles of Accounting, Volume 1: Financial Accounting15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

After examining all the relevant factors, Dale and Ciara decide to create their landscaping partnership. After much discussion, they agree on the name Acorn Lawn & Hardscapes. The first step is to formally document the actual partnership agreement. While a handshake would work, it is far more sensible to document it in case of disagreement.

Creation of a Partnership

Ideally, the agreement to form a partnership should be in the form of a written contract. This partnership agreement details the partners’ roles, the way profits and losses are shared, and the contributions each partner makes to the partnership. It also should contain basic information such as the business’s name, its location, its purpose or mission, the names of the partners, and the date of inception. Even more importantly, it should outline the following information. There is no legal requirement for a written partnership agreement. In fact, individuals can end up in court after forming a partnership agreement by accident with no written documentation. It is strongly suggested that any business relationship has a written agreement. A properly drafted agreement will often contain the following details:

  • capital contributions of each partner
  • allocation of profit, losses, and draws (withdrawals) among the partners
  • partners’ authority and decision-making role
  • process for change in partners
  • process for partnership dissolutions
  • process for settling disputes

The partners should also consider the following items:

  • Name of the partnership. The business needs a name. Many partnerships are named for the partners or the location, or the partners can choose and register an invented name. In many situations, if you are using an invented name you must file a Doing Business As (DBA) statement with the appropriate governmental agency.
  • Contributions to the partnership. Important to the start of any business is finding the capital and equipment with which to begin. The partners should agree up front about what each partner will contribute, how the contribution will be recorded, and how the investment will affect each partner’s share of ownership. For example, it is common for a partnership to allocate an ownership interest to a partner who has valuable experience or contacts in an area of interest to a partnership. Partners can also contribute service to the partnership rather than assets. Failure to address these details can derail a business before it even starts.
  • Partners’ authority. As you’ve learned, mutual agency can allow every partner to bind the partnership in agreements with outside vendors or lenders. If the authority of each partner has not been documented, problems can arise. Thus, it is important to outline who is responsible for what. The same goes for decision making. A strong agreement will outline how decision are made and at what thresholds all the partners need to be involved. A final point to cover is how management responsibilities will be divided up.
  • Allocation of profits, losses, and draws. How will the partners share in the profits or losses of the partnership? Will any of the partners receive a guaranteed payment (salary)? If so, how much? Each partner is going to have different needs and requirements, and these should be agreed upon to avoid dispute.
  • Change in Partners. At some point there may be a change in partners – whether it is an addition or a withdrawal. A well-drafted partnership agreement will create rules for how that can happen.
  • Dispute resolution. Selecting a means to resolve conflicts may one may be the most important choices for the new partners to make. It is human nature to disagree; the partnership agreement should cover how disputes will be handled so they do not interrupt business in the future.

Once the partnership agreement is complete, there are other steps to take to create the business as a legal entity.

  1. Select the state in which you plan to operate. Typically, partnerships choose the state in which they are located. Since the partnership does not pay taxes and regulations are limited, state selection is not as important as it is for a corporation.
  2. Register the name with the authorities required by the state in which the partnership is formed. This allows the partnership to use the name and prevents others from selecting it.
  3. Obtain the required business licenses. If your partnership will be selling items subject to sales tax, you will need to obtain a sales tax license. If you are operating as a professional services firm, there may be state licensing requirements – attorneys, physicians, and certified public accountants (CPAs) are especially subject to license requirements.

Ethical Considerations

Ethical Obligations to Partners

Recall that each partner is jointly and severally liable for all the debts of the partnership, meaning each partner is personally liable for these obligations. As a result, in most business settings and jurisdictions, the actions of any partner are attributed to the partnership and each of its partners, whether the actions were approved by all partners or not. For example, if partner A signs a loan agreement on behalf of the partnership and the partnership defaults on the loan, partner B can be personally liable for the loan, even though this partner had no role in signing the initial agreement.

Due to this unlimited liability, whether there is a written partnership agreement or not, partners have an ethical duty to act in the best interests of the partnership and of each of their partners. This is generally called a fiduciary duty. A fiduciary is someone who has a legal and/or ethical obligation to act in the best interest of others in order to maintain a relationship of trust and confidence. What this means in practice is that partners are to avoid actual and potential conflicts of interests, and there is to be no self-dealing. Partners are expected to put the partnership’s interest ahead of their own.

Formation of the Partnership

Each partner’s initial contribution is recorded on the partnership’s books. These contributions are recorded at the fair value of the asset at the date of transfer. All partners must agree to the valuation being recorded.

As an example, let’s go back to Dale and Ciara. On January 1, 2019 they combined their resources into a general partnership named Acorn Lawn & Hardscapes. They agree to a 50:50 split of income and losses. As stated earlier, Ciara will invest cash and Dale has real assets to contribute to the partnership.

Dale’s contributed assets include lawn equipment that he bought or created based on his specific needs. The equipment had a book value (determined in the process of filing Dale’s past individual income taxes) of $5,600 and a fair market value (the current price at which it would sell) of $6,400. He also contributed accounts receivable from his business with a book value of $2,000. However, he expects to collect only $1,600 of it, so he is contributing accounts receivable with a market value of $1,600. Since Ciara contributed cash of $8,000 and no other assets, her contribution has a book value and a fair market value of $8,000 (Figure 15.2).

Note this point about the formation of a partnership when its assets’ fair market value differs from their book value: it wouldn’t make sense to base the value of the capital contribution of assets (or liabilities) on their book value. To see why, consider the equipment and accounts receivable contributions made by Dale. The equipment had a book value of $5,600 and a fair value of $6,400. Why should Dale get credit for a contribution of only the $5,600 book value when he could have sold the equipment for $6,400 and contributed $6,400 in cash, instead of the equipment with a fair value of $6,400?

The same principle applies to Dale’s Accounts Receivable but in the opposite direction. Dale is contributing Accounts Receivable with a book value of $2,000, but since the partnership expects to collect only $1,600, that is the amount of capital contribution credit he will receive.

Book value Ciara: Cash $8,000; Total $8,000. Book value Dale: Equipment 5,600; Accounts receivable 2,000; Total $7,600. Fair value Ciara: Cash $8,000; Total $8,000. Fair value Dale: Equipment 6,400; Accounts receivable 1,600; Total $8,000.
Figure 15.2 Assets Invested by Partners at Book Value and Fair Value. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The journal entries would be as follows:

Journal entries. First entry dated January 1, 2019. Debit Equipment 6,400, and Accounts receivable 1,600. Credit Dale, Capital, 8,000. Explanation: “To record partner assets contributed.” Second entry dated January 1, 2019. Debit Cash, 8,000. Credit Ciara Capital, 8,000. Explanation: “To record partner assets contributed.”

When used fixed assets are contributed, depreciation is calculated based on their fair value and the partnership’s estimate of their useful life. Fixed assets are contributed at their fair value, not the book value on the partner’s individual books before the formation of the partnership. (In our examples, assume all the partners were sole proprietors before the formation of the partnership.)

Likewise, if the partnership were to assume liabilities from one of the partners, the liability would be recorded at the current value. And, as demonstrated above, any non-cash assets contributed to the partnership should be valued at their current values.

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