Solution manual Advanced Accounting 9e by Hoyle Ch14 PDF

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Find more slides, ebooks, solution manual and testbank on CHAPTER 14 PARTNERSHIPS: FORMATION AND OPERATION Chapter Outline I. Business organizations that are formed legally as partnerships, although they are not always as visible as corporations, still proliferate throughout this country especially ...

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CHAPTER 14 PARTNERSHIPS: FORMATION AND OPERATION Chapter Outline I.

Business organizations that are formed legally as partnerships, although they are not always as visible as corporations, still proliferate throughout this country especially in the legal, medical, and accounting professions. A. Advantages of the partnership format include ease of creation and the absence of the double taxation effect inherent to the income earned by a corporation and distributed to its owners. B. Partnerships, however, rarely grow to a significant size (when compared with large corporate organizations) primarily because of the unlimited liability being assumed by each general partner. C. Alternative legal formats have been created over the years to combine the benefits of corporations and partnerships such as S corporations, limited liability partnerships, and limited liability companies.

II. Partnership accounting and the capital accounts A. The distinctive aspects of partnership accounting center on the capital accounts maintained for each individual partner. B. The basis of accounting for these capital balances is the Articles of Partnership agreement which establishes provisions for initial investments, withdrawals, admission of a new partner, retirement of a partner, etc. C. The actual contribution made by the partners to the business should be recorded at fair market value. A problem arises, however, when a contribution is truly intangible such as a particular expertise or an established client base. 1. In the bonus method, only identifiable assets are valued and recorded. The capital account balances are then aligned to indicate the percentage of the actual contributions being made by each partner. 2. In the goodwill method, the amount being contributed and the corresponding percentage of the initial capital balance are used to calculate the value of the business and the presence of goodwill, a figure which is physically recorded as an intangible asset. III. Allocation of income A. At the end of each fiscal period, the revenue and expense accounts must be closed out with the resulting income figure being assigned to the individual capital accounts. B. The method of allocating income to the capital accounts should be established within the Articles of Partnership.

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1. The partners can simply assume an equal division of profits and losses. 2. The partners, however, can select any method that is designed to arrive at an equitable allocation. Such factors as the amounts of capital invested, the time worked in the business, and the degree of business expertise may all serve to influence the assignment of income. IV. Accounting for partnership dissolution A. Over time, the identity of the individuals within a partnership can change through admission of a new partner or the death, retirement, or withdrawal of a present partner. B. Each change in composition serves to dissolve the original partnership usually so that a new partnership can be formed to continue the business. Thus, dissolution does not necessarily affect the operations of the business. C. Admission of a new partner. 1. A new partner will often buy all (or a portion) of the interest owned by one or more of the present partners. a. The capital account balances can simply be reclassified to reflect the identity of the new ownership. b. As an alternative, all accounts may be adjusted to fair market value with the price paid being used as the basis for calculating any goodwill. 2. A new partner can also be admitted by a direct contribution to the partnership business. a. The bonus (or no revaluation) method records the identifiable assets being contributed at fair market value. The new partner’s capital is set equal to a prearranged percentage or amount. The remaining capital balances are then aligned based on profit and loss percentages. b. The goodwill (or revaluation) approach initially adjusts all assets and liabilities of the partnership to fair market value and records goodwill based on the amount being paid (which is used to calculate the implied value of the business). D. Withdrawal of a partner 1. The final asset distribution to an individual should be based on the agreement established in the Articles of Partnership and will often vary in amount from that partner's ending capital balance. 2. The difference between the amount paid and the final capital balance can simply be recorded as an adjustment to the remaining partners' capital accounts in the same manner as the bonus method. 3. As an alternative, all accounts can be adjusted to fair value with the amount of payment being used as the basis for computing goodwill.

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Learning Objectives Having completed Chapter 14 of this textbook, "Partnerships: Formation and Operation," students should be able to fulfill each of the following learning objectives: 1. Discuss the advantages and disadvantages of organizing a business as a partnership instead of as a corporation including such factors as the ease of formation, taxation effects, and the unlimited liability of the partners. 2. Describe the purpose of an Articles of Partnership and list specific items that should be included in this agreement. 3. Prepare the journal entry to record the initial capital investment made by a partner when either cash or another asset is being contributed. 4. Use both the bonus method and the goodwill method to record a capital investment made by a partner who is contributing an attribute such as a specific expertise or an established clientele. 5. Understand the impact that the allocation of income earned by a partnership has on the individual capital balances. 6. Allocate income to partners when interest and/or salary factors are included. 7. Discuss the meaning of a partnership dissolution and understand that a dissolution will often have little or no effect on the operations of the partnership business. 8. Prepare journal entries to record the acquisition by a new partner of a current partner's interest. These entries should be made both as a reclassification as well as by means of the goodwill approach. 9. Prepare journal entries to record a new partner's admission by a contribution made directly to the partnership. These entries should be made both by the bonus method as well as by the goodwill method. 10. Prepare journal entries to record the withdrawal of a current partner. These entries should be made by the bonus method, the goodwill method, or a modified method whereby assets and liabilities are revalued but no goodwill is recognized.

Answers to Discussion Questions What Kind of Business is This? The owners of this business face a common problem: they have started operations without giving serious consideration to the legal formation of the company. The accountant now needs to spell out for them the advantages and disadvantages of creating a partnership versus a

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corporation or some other type of legal form. Eventually, the owners must make this decision but they should consider all of the relevant factors before arriving at their choice. The accountant should discuss the following issues with the two owners: —Ease of formation. A formal partnership can be created by the writing of an Articles of Partnership. If the allocation of income and the contributions by the partners have already been resolved, the development of this document should be relatively simple. Forming a corporation can be a more difficult task but the degree of difficulty does depend on individual state laws. Normally, the documents to be completed are more complicated although that is not necessarily so. The accountant should explain the specific procedures that apply to partnerships in the state where the business is organized and conducts its operations. —Business liabilities. In a partnership, either partner may be held liable for all business debts. Thus, if liabilities escalate and the business fails, each partner does risk the possible loss of an enormous sum. The same problem would not exist in a corporation where owners and the business are considered separate entities. For the owners, potential losses are, in corporations, normally limited to the amount being invested. However, in many small, newly created, corporations, the owners are required to personally guarantee any loans. Therefore, to an extent, the concept of unlimited liability may actually be present in either case. The partners should forecast the amount of debts that will be incurred and the possible outcome if the business would happen to fail. —Lawsuits. Some businesses are more susceptible to lawsuits than others. A florist, for example, would seem to have less risk than a pharmaceutical company. The concept of personal liability for business debts becomes especially important in a business with a high possibility of litigation and resulting losses. In a business with such a risk, creating a corporation to protect the personal property of the stockholders would appear to be a wise move. The owners of a partnership might become personally responsible for losses created by a business mistake or accident. Obviously, this need for responsibility is recognized in states that prohibit doctors, lawyers, accountants, and the like from incorporating. This is a primary reason for such states to allow licensed professionals to operate LLPs. —Taxation. In a partnership, all income is allocated to the owners immediately and they are taxed on this amount. Double-taxation is avoided. A corporation pays an income tax and any dividends are then taxed again when collected by the owners. Therefore, traditionally, partnerships are viewed as having a tax advantage. The accountant should also mention to the partners other possible tax factors that may affect their decision. For example, in small corporations, double taxation may not be a problem. If salaries paid to the owners are reasonable and approximate the company's profits so that no dividends are distributed, only one tax is paid in either case. As another issue, if a partnership suffers a loss (which often happens when companies begin operations), that loss is passed to the partners and can be used to reduce other taxable income. However, in a corporation, losses are carried back and forward to reduce other taxable income that is earned by the business, possibly delaying the benefits of the loss. As mentioned in the textbook, the owners should consider forming an S Corporation—a business that is incorporated but still taxed as a partnership.

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—Bankruptcy. If the business should ever fail and have to be liquidated, losses of a partnership are passed directly to the owners to reduce taxable income immediately. For a corporation, the loss is a capital loss to the stockholders which can only offset their own capital gains or be deducted at the rate of $3,000 per year. Thus, if a large loss is incurred, the tax benefits may not be realized for years into the future. —Growth potential. Traditionally, corporations have more growth potential than do partnerships. Ownership interests can be easily transferred. The limitation on liability encourages ownership by individuals who cannot participate in the management of the company. Partnerships are more restricted in adding new owners. Partnerships usually have to entice individuals who are willing to work in the business in order to obtain additional capital. Therefore, the accountant may want to address the following questions in advising these clients:  What amount of time and energy is involved in becoming incorporated?  How much profit or loss is anticipated from the operations of this business in the foreseeable future?  How much debt will the new business incur?  Will this debt be guaranteed by the owners?  How much salary do the owners anticipate withdrawing from the business?  What are the chances of incurring lawsuits?  What is the possibility that the business will fail?  How large do the owners expect this business to grow? Do they anticipate the need for new owners and new capital?  Does the creation of an S Corporation apply to this particular business? How Will the Profits Be Split? This case is designed to point up the difficulty of designing a profit-sharing arrangement that is fair to all parties. Currently, these three individuals have incomes totaling an amount in excess of the first year income that is expected. Thus, the adopted plan will have an immediate impact on them. The reduction of income must be absorbed by the partners in some equitable manner. In addition, the income is projected to increase relatively fast so that the agreed-upon method needs to reward all participants properly over time. Dewars has built up the firm and still handles the bigger clients although he plans to reduce his workload over the next few years. Thus, one method of compensation would be to credit him with interest on the capital built up in the business. However, if that number alone is used, it will tend to escalate even if his work hours are reduced. For this reason, Dewars' share of the profits could also be based in some way on the number of hours that he works. According to the information presented, this number will probably shrink over the years, reducing the profits allocated to Dewars. Thus, this partner might be given interest equal to 10 percent of his capital balance and $50 for each hour worked.

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Huffman is contributing a significant number of hours to the firm but tends to work on the smaller jobs. A possible allocation technique would be to give this partner a per hour allocation but one that is somewhat smaller than Dewars. For example, Huffman could receive an income allocation of $30 per hour to begin. That number could then be programmed to escalate over the years as Huffman starts to take over the bigger jobs. Scriba's role is to develop a tax practice within the firm. Consequently, one suggestion would be to credit her capital account with a percentage of the tax revenues (20 percent, for example) each year. In that way, she benefits by the amount of business that she is able to bring to the organization. During the first years, though, she may have trouble getting the new part of this business to generate significant revenues. Thus, the partners may want to set a minimum figure for her income allocation. She could be credited, as an example, with 20 percent of tax revenues but not less than $50,000. Many answers to this question are possible. The above is just a simple suggestion based on the facts presented in the case. Income allocation techniques are usually designed to reward the partners for the attributes that they bring to the organization. Even with the above system, percentages would still be necessary to assign any remaining profit or loss. If the partners are not totally satisfied with the system as designed, the percentages could be weighted or adjusted to reward any partner not being properly compensated.

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Answers to Questions 1. The advantages of operating a business as a partnership include the ease of formation and the avoidance of the double taxation effect that inherently reduces the profits distributed to the owners of a corporation. In addition, since the losses of a partnership pass, for tax purposes, directly through to the owners, partnerships have historically been used (especially in certain industries) to reduce or defer income taxes. Several disadvantages also accrue from the partnership format. Each general partner, for example, has unlimited liability for all debts of the business. This potential liability can be especially significant in light of the concept of mutual agency, the right that each partner has to create liabilities in the name of the partnership. Because of the risks created by unlimited liability and mutual agency, the growth potential of most partnerships is severely limited. Few people are willing to become general partners in an organization unless they can maintain some day-to-day contact and control over the business. Further discussion of these issues can be found in the Answer to the first Discussion Question that appears above. 2. Specific partnership accounting problems center in the equity (or capital) section of the balance sheet. In a corporation, stockholders' equity is divided between earned capital and contributed capital. Conversely, for a partnership, each partner has an individual capital account that is not differentiated according to its sources. Virtually all accounting issues encountered purely in connection with the partnership format are related to recording and maintaining these capital balances. 3. The balance in each partner's capital account measures that partner's interest in the book value of the business’ net assets. This figure arises from contributions, earnings, drawings, and other capital transactions. 4. A Subchapter S corporation is formed legally as a corporation so that its owners enjoy limited legal liability and easy transferability of ownership. However, if a company qualifies and becomes a Subchapter S Corporation, it will be taxed in virtually the same manner as a partnership. Hence, income will be taxed only once and that is to the owners at the time that it is earned by the corporation. Use of this designation is quite restricted. To qualify as a Subchapter S Corporation, a company can only have one class of stock and must have no more than 100 owners. These owners can only be individuals, estates, certain tax-exempt entities, and certain types of trusts. Most corporations that do not qualify as Subchapter S Corporations are automatically Subchapter C Corporations. These entities are also corporations but they pay income taxes when the income is earned. Additionally, the owners are liable for a second income tax when dividends are distributed to them. Thus, the income earned by a Subchapter C Corporation faces the double taxation effect commonly associated with corporations. 5. In a general partnership, each partner can have unlimited liability for the debts of the business. Therefore, a partner may face a significant risk, especially in connection with the actions and activities of other partners. However, general partnerships are easy to form and often serve well in smaller businesses where all partners know each other. The major Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

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advantage of a general partnership is that all income earned by the business is only taxed once when earned by the business so that no second tax is incurred when distributions are made to owners. A limited liability partnership (LLP) is very similar to a general partnership except in the method by which a partner’s liability is measured. In an LLP, the partners can still lose their entire investment and be held responsible for all contractual debts of the business such as loans. However, partners cannot be held responsible for damages caused by other partners. For example, if one partner carelessly causes damage and is sued, the other partners are not held responsible. A limited liability company can now be created in certain situations. This type of organization is classified as a partnership for tax purposes so that the double-taxation effect is avoided. However, the liability of the owners is limited to their individual investments like a Subchapter C Corporation. Depending on state law, the number of owners is not restricted in the same manner as a Subchapter S Corporation so that there is a greater potential for growth. 6. The Articles of Par...