 Hello and welcome to this session. This is Professor Farhad and this session we would look at partnership and in this session it's going to be an introduction. Basically just basic information about the partnership. So this way you have the theoretical background for the actual entries that we're going to be processing later on. So we're going to have very basic journal entries today, but it's a background about partnership. The topic is covered in advanced accounting course. It's also covered on the CPA exam, the FAR section. Now I would like to connect with my followers, with my viewers, with my subscribers and I'm very active on LinkedIn. Please connect with me on LinkedIn. I also have a Facebook page, so if you use Facebook, please like my Facebook page, Accounting Lectures. Obviously, please subscribe to my YouTube so you'll always get updates and you can follow me on my Twitter account. So let's talk about partnership. What is a partnership? Well, a partnership is when two or more individuals decide to carry a business together to share the profit. And notice here it's sharing the profit. So it's an association of two or more persons to carry on as co-owners. Basically, they're both owners of a business for profit. What are some attributes characteristic of the partnership? You must have an agreement. Now the agreement does not have to be in writing. It can be expressed, basically oral or implied. Now it's better if it's in writing, but it doesn't have to be in writing. As long as you are working together and sharing the profit, technically you are in a partnership. And the purpose of the partnership is to make a profit. So that's the purpose of it. And if you are a member, you are an owner. Co-owner means you are just an owner just like the other individual. It means you can run the company based on what you guys agreed upon. What are the advantages of a partnership? And here it's important to distinguish when we say advantages of a partnership compared to what? So we're going to look at advantages of a partnership compared to a corporation because advantages of what? Okay, for one thing, it allows you to gather money, pool resources without the complexity of a corporation. So it's easier to raise money, easier to raise capital. It's easier and less costly to establish. Again, when it comes to establishing a partnership, it doesn't mean that a corporation is difficult, but it's easier and less costly. Okay, also to start a corporation, it doesn't cost that much money, but partnership is usually cheaper. It's not subject to as much governmental regulation as corporation. Why? Because the partnership is closely related. Parties are working together. So generally speaking, the government doesn't get involved that much in comparison to a corporation, especially large corporation. When you have publicly public shareholders, then the government is much, much more involved. So it's not subject to as much regulation and also it allows partners to operate with more flexibility. Once again, you don't have governmental regulation. Also, you don't have a lot of hierarchy as much as a corporation because in a partnership, usually, if it's a small or a medium partnership, the partners know each other. So it's much easier to operate the company. You have more flexibility in operating the company. And the last advantage is income not subject to taxation at the partnership level. Now, it's worth spending a couple of minutes just to explain this concept. So let's go ahead and explain what does it mean. Income is not subject to taxation as a partnership level. Well, how does this work? So let's assume we are operating as a corporation. So let's go ahead. I'm just going to pull one note here and start to kind of work a quick example for you to show you how this works. Let's assume we are operating as a partnership and we have revenues. Obviously, we generate revenues and we generate expenses. And let's assume revenues, we generate the revenues of $100,000 and expenses of $60,000. So the profit or net income is $40,000. And for simplicity, we're going to assume we have two partners, A, partner A and partner B. And also for simplicity, we're going to assume that they own 50-50. So therefore, they share the profit 50-50. So what's going to happen is this, this net income here, $20,000 will go to partner A and $20,000 to go to partner B. Now partner A, let's assume their tax rate is whatever their tax rate is. Let's assume their tax rate is 10%. They'll pay $2,000 in taxes. And let's assume partner B, their tax rate is 20%. That's their personal tax rate. We're not concerned with this. Therefore, they pay $4,000 in taxes. Okay. So this is how a partnership works. The income goes, it's called a pass through entity, goes to the owners. Now on the other hand, if we are operating as a corporation and specifically a C corporation, what's going to happen is this, we have revenues of $100,000, we have expenses of $60,000, and that's going to give us $40,000. Well, this is called income before taxes. Why? Because the corporation itself will have to pay taxes and let's assume they have to pay 30% taxes. 30% is $12,000. So they're going to have to pay $12,000 in taxes. I'm just making this number up in case you're wondering where this number is coming. Therefore, what's left is $28,000. So this is net income. So the first thing is you want to know is the corporation paid taxes versus the partnership did not pay taxes. Now we're not done yet. Let's assume the corporation distribute the profit. So this is net income. Let's assume they distribute the profit to the shareholders and assuming they're going to distribute everything just to illustrate the point. So they're going to distribute $14,000 to shareholder A and $14,000 to shareholder B. Guess what's going to happen again? Shareholder A will have to pay 10% taxes, which is $1,400, and partner B, their tax rate is 20%. They're going to have to pay $2,800. So notice what happened here. The profit on this company was taxed twice. It was taxed on the corporate level right here, and it was taxed on the individual level. So this is one advantage of the partnership is the income is taxed only. The income is taxed only once. The income is taxed only once. And that's an important advantage. Now, we're going to need to talk about the partnership. Generally speaking, I'm going to simplify this. We're going to have two types of partnership. Although in the real world, we have more than two types just for simplicity. And just because we don't want to go too much into this topic, because it's beyond the scope of advanced accounting, it's basically more likely business law. But basically, we have two types of partnership. We have a general partnership, which is right here, and we have LP limited partnership. So we need to know how general partnership, what are the characteristics of a general partnership, and the characteristic of the limited partnership very, very briefly. Okay, in a general partnership, if you have it, if it's considered general partnership, each member is a general partner. So basically all members or each. So in a general partnership, all members are general partners. Okay, what does that mean? It means they have they all have a mutual agency. What does mutual agency mean? It means they can represent the company, they are agent of the partnership. Mutual agency means as a partner, I can represent the company, I can enter into a contract on behalf of the company. And my, my, my, my other partner can do the same thing. You could also you have the right to dispose the partnership interest. Obviously, if you don't like it, you could just sell out. You have unlimited liability. This is an important characteristic of a general partner. The fact that they have unlimited liability, it means they are responsible for the debt. And anything that happens to the company, they are personally responsible, the debt as well if there is any lawsuits, they are personally responsible for the losses, limited or uncertain life in a general partnership. If a partner withdrawal, then basically the partnership is done. If there's a death, the partnership is done, if the court decided that the partnership need to be absolved, the partnership is done. So those are some characteristics of a partnership. In a limited partnership, to have a limited partnership, well, a limited partnership, you could have for example, you know, five individuals, I'm just going to draw five just for the sake of illustration. Okay, you could have five individuals. And for a partnership to be to have a limited partnership, at least one of them have to be a general partner. Okay, general partner versus the other four can be limited partners. So those are limited partners. Now, now I did not explain what does it mean to be a limited versus a partnership. So when do we create a limited partnership? When is a limited partnership created? A limited partnership created when one individual, this general partner, they got a good idea, good business idea, but they don't have the money. Okay, they have a good idea. They can run a business, they know what they're doing, but they don't have the money to run the business. So what they do is they go to the two other partners and tell them, look, we have this great idea, but I need money to operate the business. Well, these partners, those four partners, they have the money, they got the money, but they don't understand the business that much, and they're not interested in running the business. And also they don't want to have, remember, they don't want to have unlimited liability, because if they have unlimited liability, they expose themselves, they expose their wealth or assets to the partnership. So what they would say, they would say, okay, we're willing to give you money. However, we want to be considered limited partners. So we are limited partners, not general partners. So simply put, to have a limited partnership, you still have to have one general partner, one that's responsible. So basically somebody has to be responsible for everything. And that's the general partner, you could have more than one general partner, but at least one general partner, and you could have the remainder of limited partners, it doesn't matter. So the general partner usually manages the firm because the limited partners are not interested. That's not what they want to do. And two, they're liable for the obligation for anything that happened to the partnership. The limited partners, basically they're capital providers, they invest money only, that's their job, that's their role. They have a limited liability and that's important. Whoops. Sorry, just skip. They have, they have limited liability because that's why they want to be a limited partner. They don't want to have unlimited liability. And they don't participate in management. And that's important because if they participate in management, they might become a general partner. So kind of they're silent, they're silent partners. Okay. And basically, a limited partnership allow general partner to raise capital without given up management control. Also another reason, let's assume a general partner needs money, but they don't want anyone to participate in management with them. They would say, okay, I will make you a limited partner. And that's why that I will have a limited partnership. Now, again, I am kind of simplifying the word of partnership into a general and limited partner, we have different types of partnership, just want to let you know this. Also, we have something called the joint venture, which is a little bit different. Joint ventures are arranged by two or more parties to accomplish a single or limited purpose for their mutual benefit. Think of it, two parties, they decided to form some type of a corporation or a partnership called a joint venture to to serve a purpose, for example, to go into a real estate limited, limited time horizon project, they want to build, you know, a stadium and they want to to gather do it, but they want to have this relationship very limited at the stadium. So there is a life limited to that to that undertaking. So just building a stadium, relationship is governed by you have to have a written agreement here, because at the end, we're going to have to dissolve this partnership, each party participate in the overall management. So and they participate in managing this business, they usually organize it as a corporation or as a partnership, and they call it a joint venture. So you need to know what a joint venture is, because you wanted to differentiate it from partnership, general or limited, or this could be who knows, and a questions on the CPA exam. So what should the partnership agreement include? So when you form a partnership, what does it include? Now we're going to have a list of items, just kind of laundry list of things one, the name of the firm identity of the partners, who are the people? Okay, who are the people that obviously we need to know this? The purpose of the partnership, the nature of the purpose and the scope of its business, what do they do? Effective date of the organization, when did they start length of time a partnership is to operate with has a limited life like a joint partnership, we need to know this location of the place of the business, where are you operating? Also provision for allocating profit and loss, you don't have to have this, you don't have provision, if you don't have provision, everything is split 50, 50, just like forest dump, okay? Provision for salaries and withdrawals by partners, also, if there's any salaries or withdrawal by partners, we need to agree on those numbers. Rights, duties and obligation for each partner, authority of each partner in contract situation, can you go into a contract, can you go not into a contract, you have unlimited agency, limited agency, authority, so on and so forth. Also, you would include procedures for admitting new partners, so when you want to bring a new partner in, what are the procedures that we vote on it? Is it the majority, the simple majority, so on and so forth. Procedures for withdrawal or that of a partner, what happened when a partner withdraws or dies? Procedures for arbitrations of dispute, if we have a dispute, what are, how do we resolve this dispute? Do we take it to the court or are we going to agree to solve it by a third party, agree to an arbitrator? Physical period of partnership, is it going to be a calendar year, physical year, if it's a physical year, what is our physical year, okay? Identification and valuation of initial asset investments and capital interest. And we're going to talk about this later on when you contribute asset, how do we determine how much is the asset is worth, okay? Do we bring an appraiser, do we agree on it, do we look it up on the internet, how do we do so? Situation for partnership, the solution and provisions for terminating or continuing the business. So when do we, when do we, when do we stop, when do we terminate this business, when do we keep on going, what are the conditions, okay? Accounting practices to be followed, are we going to be using the cash method, the cruel method, which method are we going to be using, whether we need or not need an audit, do we need to have an audit, do we need to have a third party assurance or are we all okay not having an audit? So those are, are these a limited, a limited list and obviously it's not, you can add any agreement, any, any, any, any additional conditions you would like to. We need to differentiate between capital interest and a partnership versus a profit interest, okay? So what is the capital interest? It's basically your capital account. What is your capital account? It's your equity. So capital interest is the claim against the net asset, which is basically your equity, okay? This is what capital interest is. So your equity could be, you know, $100,000, which could be, you know, representing 10% of the company. So if the company, if the total equity is a million, if all capital is a million and you own 100,000 of that capital, then you are 10% owner. Now differentiate between this capital interest and interest and income and losses. Now how partner capital interest will increase or decrease as a result of subsequent operation? Now, now remember your profit interest does not have to be the same as your capital interest. So if your capital interest is 10%, it doesn't mean you're going to get 10%. You may get 10% if that's what we agree on. We might agree that income is always equal to your capital interest, to your capital interest percentage, but it doesn't have to. So differentiate that you could have a capital interest and you could have a profit interest. Your profit interest and capital interest could be different, okay? Now your capital interest, it's going to increase when you generate a profit. It's going to decrease when you have a withdrawal. We'll talk about this, but what you need to know is your capital interest and how we allocate income and losses are two different things, okay? Generally speaking, partnership basically follows gap, but you don't have to. If it's a small partnership, you may use the cash basis or you may use tax basis of accounting. Now I'll tell you when I was in business, when I was in practice, most partnership, the majority of them, they were medium, small to medium partnership and they all followed tax basis of accounting. Why? Because they wanted to save money. How do you save money? Just do my books based on tax rules because I need to file my taxes. If you do it on cash basis, then you have to move it into tax basis. If you do it under gap, then you have to do it on tax basis. So it saves the company money because you have only one set of books. But again, that's optional. Maybe if you want to get a loan, the bank wants gap or cash basis is easier for you, but based on my experience, most of the partnership that I work with at least, they were tax basis and the reason is it's much cheaper and it's easier for the accounting firm. I mean, we don't like this. We want to prepare your books based on two sets of books. So we charge you more money. But for me as a staff accountant, that was easy. It was okay. All the books are tax basis. I can prepare the income tax return. So when I started, I liked it. I didn't have to do any conversion. Okay. So once again, the partner's interest in their income or loss may not be proportional to their capital interest. I talked about this. So your capital interests and your participation in income and loss are not the same. And don't worry, we're going to talk about this much, much more in details. How do we allocate income? Now, the partner equity section. So when we have a partnership, how does the equity, what does the equity section looks like? Well, it's going to have actual names. So it's going to have the name of the person. For example, if I'm a partner, it's going to have far hat comma capital. I'm going to have my own account. You're going to have a capital account for each individual. You're going to have Tom comma capital and the dollar amount obviously. Okay. So you're going to have a capital account for each partner. You're also going to have a drawing account. For example, far hat, we're going to have a far hat drawing. We're going to have a far hat drawing account. Tom, we're going to have Tom drawing account. And this account will keep track of the withdrawals. Basically, it's like dividend. Okay. So typically, we debit to record withdrawal of an asset and it's a patient of profitable operation or payment of personal expenses of a partner from partnership assets. So basically, when the partner takes money out, we debit this withdrawal account. And don't worry, we're going to do accounting shortly, basic accounting about this. Okay. Now, I still remember when I was in practice, funny story is when you have a family operating as a partnership and especially a pizzeria doesn't have to be a pizzeria, but usually it was. I remember a pizzeria that you used to have. And we have like a company where they have the same name, like the grandfather owned the partnership, the father, the kid, the uncles, and they all called, you know, they named the same thing like Tony, I'm not going to say the last name, but you know, Tony something. And you have the first, the second, you know, Tony, then you have a different middle name, but it was always the first and last name, the same, but either the first, the second or the middle name was different. And you had to be very careful, very careful in determining who took what out of the business to keep track of their withdrawal. So that was interesting because you had so many Tonys in the same business with the same last name. So what we do, I still remember what I used to do is to basically identify them with the last four digit of their social security to identify which is which. So it was kind of difficult as like 10 to 12, same people with the same last name, large family. That's that. So and we do close periodically to capital accounts. What do we do? The drawing account that's close to capital account, just like we close dividend. And don't worry, we're gonna work an example next. So let's take a look at this example to see how this all fits together. So we have Tom and Julie formed a management consulting partnership on January 1st. The fair value of the net asset invested in the partnership is as follows. So we have Tom and we have Julie, two partners and each one of them they're gonna contribute a certain amount of assets and money into the partnership. All they could also contribute liability. So let's first look at Tom. Tom contributed cash, accounts receivable, office supplies, office equipment, and somehow they contributed accounts payable. So how do we do? So basically what's how much did Tom contributed? Well, guess what? Let's add up all the assets. Okay, 13,000 plus eight plus two, that's 23. 23 plus 30 is 53. Okay, so the total contribution of assets is 53. Okay, so that's 53. Then remember Tom contributed 2,000 in liabilities. The liabilities it's gonna reduce because now you are transferring the obligation to the partnership. Well, guess what? That's not really capital. If you're transferring a liability, it's gonna reduce. So basically your net asset, it's gonna reduce your asset position. This is the net asset that you contributed. And this is gonna be equal to your capital contribution. So simply put, it's your asset minus your liabilities. The net is what you really contributed. Okay, so let's do the journal entry for Tom before we proceed. So for Tom, we will debit cash, we will debit accounts receivable, we will debit office supplies, we'll debit office equipment. So those are all the assets. We credit the liability, accounts payable, and Tom capital is 51,000. So this is the initial contribution of Tom's capital. Okay, this is the entry. Now let's go back and do the same thing for Julie. Julie contributed 12,000 in cash, 6,000 in receivable, 800 in supplies. So that's 18,000. So assets of 18,000 also land. Also land 18,800 plus land plus 30,000. That's equal to 48,800. Now, what comes with those assets also what Julie contributed is a liability. And when we contribute a liability, it's gonna, it's, we have to reduce your net asset by the liability. You contributed payable and you contributed a mortgage payable maybe for the land. So if we take 48,800 minus the liability, 18,800, it should give us 25,000. So that's your net asset. So let's do the entry for Julie. Julie contributed cash, we debit cash, contributed assets of receivable, office supplies, land. Those are the assets contributed accounts payable of 5,000, mortgage payable of 18,500. Therefore, the capital is the difference between assets and liabilities. Now make sure when you add up all the assets, I'm sorry, when you add up all your debits equal to your credits and they should equal to each other. Okay, so let's go back and see what happened next. So we did the initial contribution of each partner. So let me just clear this. So this is the initial contribution. During the year, Tom withdrew $15,000 and Julie withdrew $12,000. So how do we do overdraw? As I told you, we're gonna have a drawing account. So for Tom, we're gonna have Tom, comma, drawing, which is a debit, and we're gonna debit this account 15,000. And they can, they withdrew cash, we credit cash 15,000. And the same thing for Julie. Julie withdrew 12,000. We'll do the same thing. So let me show you the entry for Tom and Julie. Tom drawing is 15,000 and Julie, Julie drawing should this should be drawing that capital. Julie drawing is 15,000. Okay, what's next? Let's see what happened next. Next is net profit for 20, 2008 was 50,000, which is to be allocated based on the original net capital investment. Okay, so the partnership made a profit of $50,000. Now how are we gonna allocate the profit? Because again, the profit is allocated to the partners. How are we gonna allocate the profit? Well, they're saying use their capital investment. Okay, what does it mean use their capital investment? It means what's their initial investment? Let's take a look at Tom. Tom 51,000. And the Julie was how much? Julie was 25. So 25 and 51. Okay, so let's do this. So we have 51 for Tom, 51 for Tom plus 25 to Julie. The total capital for both is 76,000. Now what we do is we is we take 51 divided by 76 and 67% goes to Tom. So Tom's gonna get 67% and Julie will get 33%. 33% and 66%. Now all we have to do now take the 50,000, take the 50,000, multiply it by 0.67, and we're gonna allocate approximately 33,500. Now it's surrounding, but I'm just gonna 33,500 goes to Tom. And the remainder, which is 16,500 goes to Julie. So again, of the 50,000, we're gonna allocate 67. We said 33,500 and 16,500. So this is how we allocate the dollar amount. Now we need the journal entry. Now how do you allocate? So how do you allocate the amount? How do you allocate the amount for Tom? And how do you allocate the amount? Well, here's what's gonna happen. Here's what's gonna happen. After you compute all your profit and losses. So after you compute your profit and losses, okay, you have to allocate the profit. The profit is it's gonna be an income summary. So let me show you how it works first. So here's how the closing process work. We have revenues, we have expenses. And I'm just gonna make revenues equal to 150, expenses equal to 50,000. And we have many expenses. I'm just simplifying. So what's gonna happen is this, when we close a partnership, first we debit revenues to make revenues goes down to go down to zero because we're closing revenue. And when we credit revenue, we close it to an account called income summary. So we debit revenues, we're gonna credit income summary 150,000. Then when we close expenses, we could have many expenses, we're gonna credit expenses, make expenses go down to zero, and we will debit income summary. Now, I'm sorry, I have to make this 100,000. Give me one moment. Let me just erase this real quick. So I'm gonna make expenses equal to 100,000 not because I want the profit of 50. So I'm just gonna change the expenses into 100,000. So I have 100,000 of expenses. I'm gonna close it, credit expenses, debit income summary. So now what I have an income summary is $50,000. Okay, this is the profit. This is revenues minus expenses. Now, how do you close the profit? How do you close the profit? So how do you distribute the profit to the partners? What's gonna happen is you will debit income summary and you credit Tom and you credit Julius. So simply put, you're gonna debit this account 50,000 of which $16,500 goes to Tom and $33,500 goes to Tom and $16,500 goes to Julius. So this is how we end up an income summary. So we have $50,000 in income summary, you debit income summary and you credit the capital account. So let me just show you the journal entry now. So the journal entry would look like debit income summary, credit capital, it's rounding. I did $5,516,500 just because of rounding. My numbers are a little bit different. Then remember at the end of the period, you also have to close the drawing account. Remember Tom took $15,000, so you credit the drawing, debit the capital. So simply put, let me show you what happened to the capital account for Tom. So Tom, capital. Tom started with a partnership interest of $51,000. Then the partnership made $33,500. I'm just gonna put 500 in profit. So we increase, I'm sorry, we increase the account, not decrease the account. So let me erase this. Then Tom withdrew $15,000. Now what we do is we can compute the end in capital for Tom, compute the end in capital for Tom, which is we started with $51,000 plus $33,500 minus $15,000 equal to $69,500. So we would say the end in capital is $69,500. And we could do the same thing for Julie. What was her beginning capital? $25,000. So her beginning capital for Julie was $25,000. Then she got $16,500 in income. Then she withdrew $12,000. Then you can do the math. Okay, you can do the math. So these are basically basic journal entries for accounting for partnership. In the next session, I will start to show you how do we allocate net income. Now in this situation, I told you it's based on capital interest. There are many ways to allocate capital income to capital balances. We'll see it in the next session. If you're studying for your CPA exam, I only study hard if you have any questions, email me. If you happen to visit my website for additional lectures, please consider donating or contributing money. Thank you and good luck.