CHAPTER 11 – PARTNERSHIPS
I. Partnership Form of Organization
- there are 3 forms of business organizations in Canada - Sole proprietorship
- Partnership
- Corporation
- a partnership is an unincorporated business that is owned by 2 or more people
- there are two forms of partnership under Canadian law 1. General partnership
2. Limited partnership
A. Characteristics of General Partnerships
- some characteristics of a general partnership are as follows:
Partnership Agreement
- the partnership itself is based on an agreement either verbal or written, but a written agreement
is preferable in order to minimize disagreements
- an agreement made between 2 or more legally competent people (of legal age and sound mind)
- see page 727 for items contained in the agreement
Limited life
- death or bankruptcy can end a partnership
- a partnership can be ended at will by any one partner (quit or retire)
Taxation
- a partner’s share of partnership income is taxed the personal tax return
Co-ownership of Property
- all assets are jointly owned by all parties
- partners have a claim on partnership assets based on the balance in their capital accounts
Mutual Agency
- every partner can act as an agent and commit the partnership to a contract within the scope of
the business
- partners can limit the power of a partner to negotiate contracts (this agreement is binding on the
partners and outsiders who have knowledge of the agreement)
Unlimited Liability
- if the partnership is unable to pay its debts, the personal assets of the partners can be claimed by
the creditors
- if one partner does not have sufficient personal assets to pay his share of debts, the remaining
partners are responsible for paying the debt
- see chart on page 729 for advantages and disadvantages of partnerships
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B. Limited Liability Partnerships
A limited partnership has two classes of partners
General partner(s) - has unlimited liability for debts of partnership
Limited partner(s) - has no personal liability beyond his investment in the partnership
- any role they have in management of the business is detailed in
the partnership agreement
NOTE: In some provinces there is a Limited Liability Partnership (L.L.P.) available to
professionals. This type of partnership prevents one partner from having liability of another
partner due to malpractice or negligence claims. All other partnership debts would be treated as
a general partnership.
II. Basic Partnership Accounting
Accounting for a partnership is the same as a sole proprietorship except:
1. Each partner has their own capital account
2. Each partner has their own withdrawals account
3. Division of earnings and losses by partners according to the partnership agreement
A. Organizing a Partnership
- partners can invest both assets and liabilities
- normally all investments are recorded at fair market value.
B. Dividing Income or Loss
Partners are not employees of the business they are the owners. How much income (or loss) they
have depends on how profitable the business has been. Any amounts withdrawn from the
business by the partners are their share of the business earnings or a reduction in their
investment; it is not a salary expense.
The partnership agreement should state how net income and net losses are to be allocated. If no
agreement exists, income and losses are shared equally between the partners. There are three
common methods that partnerships use to divide earnings and losses.
1. Fractional basis
- each partner receives an agreed upon fraction or percentage of the earnings and losses
(Example 2/3 - 1/3)
2. Ratio of capital investment
- earnings are allocated on basis of partner’s investment or capital account
3. Salaries and interest allowance
- earnings are allocated in three steps
a) partners have an annual salary allowance
b) partners receive interest on their capital balance
c) remaining income or loss is shared on a fractional basis
- see pages 731 to 734
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NOTE: In a legal sense, partners do not earn salaries or interest. This is just a method of
allocating partnership income and losses, and these salary and interest allowances do not appear
on financial statements.
C. Partnership Financial Statements (page 737)
The financial statements of a proprietorship and a partnership are very similar, with the
exception being the Statement of Changes in Equity. This statement shows the changes during
the year to each individual partner’s capital account.
III. Admission and Withdrawal of a Partner
- whenever a partner withdraws or a new partner is added, the existing partnership ends and a
new one may be formed
A. Admission of a Partner
1. Purchase of a Partnership Interest
- when someone purchases an existing partner's interest in the partnership, the balance in the
capital account is transferred to the new person
JE Smith, Capital 10,000
Jones, Capital 10,000
The amount of the purchase between the two parties is a personal transaction and not recorded by
the partnership. The new purchaser does not become a partner until the original partners agree to
accept the purchaser as a partner. If the new partner is not accepted, he will not have any say in
the management of the company but will receive the old partner’s share of income and losses.
2. New Partner Added
a. Investment equal to share of equity
- when value of partnership is approximately equal to equity recorded in books, new
partner receives equity of his investment
JE Cash 10,000
Jones, Capital 10,000
b. Investment greater than share of equity (Bonus to old partners)
- when value of partnership is more than what is recorded in books or if the partnership is
very successful, new partner may have to pay bonus for joining partnership
- the bonus is added to the capital accounts of the original partners based on their income
sharing agreement (Goodwill can be recorded, but is seldom done in practise)
JE Cash 50,000
Jones, Capital (new partner) 40,000
Smith, Capital 5,000
Doe, Capital 5,000
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c. Investment less than share of equity (Bonus to new partner)
- when a new partner is admitted to the partnership and has exceptional knowledge,
business experience, etc. the existing partners may be willing to pay him/her a bonus for
entering into the existing business.
- this bonus is added to the new partner's capital account
JE Cash 15,000
Smith, Capital 2,500
Doe, Capital 2,500
Jones, Capital (new partner) 20,000
- in all of the above cases the division of earnings and losses is a separate matter to be
determined between the partners
B. Withdrawal of a Partner
There are two ways a partner can withdraw from a partnership
a) sell share of partnership interest to a new partner (above)
b) receive cash and other assets from the business for their share of the partnership
1. No bonus
- balance in the retiring partner's capital account is withdrawn in cash or other combination of
assets
JE Brown, Capital 5,000
Cash 5,000
2. Bonus to Remaining Partners
Reason: 1. revaluation of assets not recorded, and assets are overvalued
2. retiring partner wants to leave business and is willing to take less than share of
equity
3. Bonus to Withdrawing Partner
Reason: 1. revaluation of assets not recorded, and assets are undervalued
2. continuing partners are anxious to have retiring partner leave the business and
are willing to pay extra or as a gift for retirement
Note: In both of the above cases 2 & 3, the difference between the cash paid out and the retiring
partners equity is allocated to the remaining partners capital accounts on the basis of their
income sharing agreement.
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C. Death of a Partner
- the partnership agreement should state what happens in the event of a death of a partner
Steps 1. Close books of the partnership to record the income or loss to the date of death.
2. Assets of the business are revalued to determine current values (any gains or losses on
revaluation are distributed according to their income sharing agreement to the partners'
capital accounts)
At this point, the deceased partner’s equity can be sold to a new partner (above), or the
partnership will pay the estate with partnership cash and other assets (above).
IV. Liquidation of a Partnership
When a partnership is liquidated, the business has ended and the books of the business are
closed. All remaining assets are then sold, creditors are paid and any remaining cash is paid out
to the partners.
There are four steps in liquidation:
1. Non-cash assets are sold and a gain or loss on the sale is recorded - this is called a gain or loss
from liquidation (realization)
2. The gain or loss from liquidation is then allocated to the partner’s capital accounts based on
the income - loss agreement.
3. All creditors are paid.
4. With the remaining cash all partners are paid the balances of their capital accounts.
a. No Capital Deficiency
- all partners have credit balances in their capital accounts (positive balances) which
equal the remaining cash balance
b. Capital Deficiency
- at least one partner has a debit balance (negative balance) in their capital account and
owes the partnership money
i. Partner pays deficit
- partner is then obligated to pay the deficit in his capital account out of personal funds, to
bring his account to zero.
JE Cash 1,500
Smith, Capital 1,500
.
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ii. Partner cannot pay deficit
- the other partners must share the deficit according to the income-loss agreement
JE Jones, Capital 750
Doe, Capital 750
Smith, Capital 1,500
- the partner with the deficit legally owes this amount to the remaining partners even
though the business is now closed
