Introduction to Partnerships & Corporations PDF

Introduction to Corporations The corporate form of organization Characteristics Operating a corporation Share capital Issuing shares Preferred shares Retained earnings Corporate income statements Cash dividends Reporting retained earnings Statement presentation an...

Introduction to Corporations The corporate form of organization Characteristics Operating a corporation Share capital Issuing shares Preferred shares Retained earnings Corporate income statements Cash dividends Reporting retained earnings Statement presentation and analysis Copyright John Wiley & Sons Canada, Ltd. 1 The Corporate Form of Organization A legal entity separate from its owners (known as shareholders) Classified by purpose and ownership: Purpose: for profit or not-for-profit Ownership: Public corporation: shares are available for purchase on an organized securities market Private corporation: shares are held by a few individuals and are not traded Copyright John Wiley & Sons Canada, Ltd. 2 Characteristics of a Corporation Separate legal existence from its owners Acts under its own name Owners do not bind the corporation Limited liability of shareholders Limited to the amount of their investment Transferable ownership rights Shares of capital represent ownership of a corporation Shares may be bought and sold No effect on operating activities of corporation Copyright John Wiley & Sons Canada, Ltd. 3 Characteristics of a Corporation 2 Ability to acquire capital Can raise capital by issuing shares May be difficult for closely-held corporations Continuous and unlimited life Unaffected by change in ownership Government regulations Specific laws that govern operations of corporations Income tax Taxed as a separate entity Copyright John Wiley & Sons Canada, Ltd. 4 Ownership Rights of Shareholders Ownership rights are in the form of shares Can be divided into different classes As stated in the articles of incorporation Each class has rights and privileges Usually referred to as common and preferred shares Shareholders have rights: To vote on certain matters To dividends: the distribution of profit To remaining assets in a liquidation Copyright John Wiley & Sons Canada, Ltd. 5 Corporation Management Shareholders manage the corporation through the Board of Directors that they elect The board: Decides on the corporation’s operating policies Selects officers (such as the Chief Executive Officer or CEO) to perform daily management functions Copyright John Wiley & Sons Canada, Ltd. 6 Share Issue Considerations Authorized share capital Number of shares company is allowed to sell Many companies have unlimited number of shares Issue of shares Issued directly to investors or through an investment dealer First public sale is called an initial public offering (IPO) Copyright John Wiley & Sons Canada, Ltd. 7 Share Issue Considerations 2 Market value of shares Once issued, shares trade on a secondary market Prices determined by buyers and sellers and other external factors Legal capital Share capital is legal capital and cannot be distributed to shareholders Retained earnings are earned capital and can be distributed as dividends Copyright John Wiley & Sons Canada, Ltd. 8 Retained Earnings The cumulative total of profit less losses and less declared dividends since incorporation Represents part of shareholder’s claim on total assets of a corporation Not a claim on any specific asset (including cash) Two major components: Profit Dividends: cash distributions to owners Copyright John Wiley & Sons Canada, Ltd. 9 Common Shares: Issuing Shares Shares are usually issued for cash: Dr. Cash Cr. Common shares Shares can be issued in exchange for services or noncash assets Recorded at fair value of goods/services received: Dr. Service or asset (e.g., Legal Fees Expense) Cr. Common shares Copyright John Wiley & Sons Canada, Ltd. 10 Preferred Shares Priority over common shares for dividends and assets in the event of liquidation of the company Entries to record issue and reacquisition of preferred shares similar to entries for common shares Transactions for each class of share is recorded in a separate account Copyright John Wiley & Sons Canada, Ltd. 11 Dividend Preference Preferred shareholders have a right to dividends before common shareholders Cumulative preferred shares have a right to current year’s dividends and any prior years’ dividends owing before dividends are paid on common shares Any unpaid dividends (in arrears) are not considered a liability No obligation to pay unless dividend is declared Copyright John Wiley & Sons Canada, Ltd. 12 Accounting for Partnerships Partnership form of organization Characteristics Advantages and disadvantages Partnership agreement Basic partnership accounting Forming a partnership Dividing partnership profit or loss Partnership financial statements Admission and withdrawal of partners Liquidation of a partnership With or without a capital deficiency Copyright John Wiley & Sons Canada, Ltd. 13 Characteristics of Partnerships 2 Association of individuals Usually based on a written agreement A legal and accounting entity, but not taxed Co-ownership of property Assets are jointly owned by partners Division of profit Partners determine how profit or loss is to be divided Otherwise shared equally Limited life Partnership ends when change in ownership New partnership can be formed to continue business Copyright John Wiley & Sons Canada, Ltd. 14 Characteristics of Partnerships 3 Mutual agency Each partner acts for (binds) the partnership Unlimited liability Each partner is liable for all partnership liabilities Special types of partnerships created to limit liability Limited partnership (LP) Limited liability partnership (LLP) Copyright John Wiley & Sons Canada, Ltd. 15 Partnership Agreement Written contract between two or more parties to form a partnership Contains basic information: Name and location of firm Purpose of the business Date of inception (formation) Specifies relationship of partners: Names and capital contributions of partners Rights and duties of partners Basis for sharing profit or loss Procedures for admission, withdrawal, death of partner, resolving disputes, liquidation of partnership Copyright John Wiley & Sons Canada, Ltd. 16 Basic Partnership Accounting: Forming a Partnership Partner’s initial investment is recorded at fair value of assets contributed As at date of transfer into partnership Values assigned are agreed to by all partners After partnership formed, accounting for transactions is similar to other types of business organizations Copyright John Wiley & Sons Canada, Ltd. 17 Basic Partnership Accounting: Dividing Profit or Loss Partnership profit/loss is shared equally Unless partnership agreement indicates otherwise The same basis of division applies to profit and losses Called the profit ratio or profit and loss ratio Each partners’ share of profit or loss is recognized through closing entries Copyright John Wiley & Sons Canada, Ltd. 18 Partnership Accounting: Closing Entries Four closing entries for partnership: 1. Close revenue accounts to income summary 2. Close expense accounts to income summary 3. Close income summary to partners’ capital accounts If profit: Dr. Income summary (= total profit) Cr. Each partner’s capital account (= their share) If loss: Dr. Each partner’s capital account (= their share of loss) Cr. Income summary (= total loss) 4. Close each partner’s drawings account to their respective capital accounts Copyright John Wiley & Sons 19 Canada, Ltd. Partnership Accounting: Profit and Loss Ratios Typical ratios used to share profit or loss: Fixed ratio: a proportion (2:1), percentage (67%) or fraction (2/3) A ratio based on capital balances at beginning or end of year or on average capital balances during the year Salaries to partners and the remainder in a fixed ratio Interest on partners’ capital balances, remainder in a fixed ratio Salaries to partners, interest on partners’ capital balances, remainder in a fixed ratio Copyright John Wiley & Sons Canada, Ltd. 20 Partnership Accounting: Profit and Loss Ratios 2 Salaries and interest: Are allocated first even if greater than profit or if partnership incurred a loss for the year Are NOT expenses of the partnership – only used to divide profit or loss among the partners Are NOT distributions of cash (or other assets) – drawings by partners are distributions Partners are neither employees or creditors Copyright John Wiley & Sons Canada, Ltd. 21 Partnership Financial Statements: Statement of Partners’ Equity The equity statement for a partnership is the statement of partners' equity Explains changes in each partner’s individual capital account and total partnership equity during the year Copyright John Wiley & Sons Canada, Ltd. 22 Partnership Financial Statements: Balance Sheet Capital balances of each partner are shown on the balance sheet in section called partners’ equity: Copyright John Wiley & Sons Canada, Ltd. 23 Admission of a Partner Causes the legal dissolution of the existing partnership and the beginning of a new partnership A new partner may be admitted either by: Purchasing all or part of the interest of one or more existing partners Investing assets in the partnership Copyright John Wiley & Sons Canada, Ltd. 24 Admission of a Partner: Purchase of a Partner’s Interest A personal transaction between one or more existing partners and the new partner Consideration exchanged is personal property of the partners involved and not property of the partnership In the partnership, only the transfer of the partnership interest is recorded: Existing partners’ equity is decreased by the amount of equity given to the new partner New partner’s equity is increased by same amount Copyright John Wiley & Sons Canada, Ltd. 25 Admission of a Partner: Investment of Assets in Partnership A transaction between the new partner and the partnership: Partnership receives assets from new partner in exchange for an interest in the partnership Both net assets and total partners’ equity of the partnership will increase Complications occur when new partner’s investment differs from the capital equity acquired: The difference is considered a bonus either to the existing (old) partners or to the new partner Copyright John Wiley & Sons Canada, Ltd. 26 Admission of a Partner: Determining Amount of Bonus 1. Determine the total capital of partnership = Capital of old partnership + new partner’s investment 2. Determine new partner’s capital credit = Total capital determined above × new partner’s ownership interest 3. Determine the amount of the bonus = New partner’s investment ± new partner’s capital credit If investment < capital credit: bonus to new partner If investment > capital credit: bonus to old partners 4. Allocate the bonus to/from old partners Based on profit ratios of old partners Copyright John Wiley & Sons Canada, Ltd. 27 Admission of a Partner: Bonus to Existing (Old) Partners Bonus to old partners may be necessary: Fair value of partnership assets may be greater than their carrying value Unrecognized good will may exist Bonus to old partners occurs when: New partner’s investment > capital credit on the date of admission to partnership Amount of bonus = difference Copyright John Wiley & Sons Canada, Ltd. 28 Admission of a Partner: Example Calculation of Bonus Old partners’ capital balance = $120,000 Peart $72,000 and Sampson $48,000 Old partners’ profit ratios: Peart 60% and Sampson 40% Trent purchases 25% share: Scenario 1: for $80,000 Copyright John Wiley & Sons Canada, Ltd. 29 Admission of a Partner: Bonus Calculation – Scenario 1 1. Total capital of new partnership: $120,000 + $80,000 = $200,000 2. New partner’s capital credit: $200,000 × 25% = $50,000 3. Amount of bonus to old partners: $80,000 − $50,000 = $30,000 4. Allocation of bonus to old partners: To Peart: $30,000 × 60% = $18,000 To Huang: $30,000 × 40% = $12,000 Copyright John Wiley & Sons Canada, Ltd. 30 Admission of a Partner: Bonus to New Partner Bonus to new partner may be necessary: New partner has resources or attributes that the partnership wants (cash, expertise) Carrying amount of partnership assets is greater than their fair value Bonus to new partner occurs when: New partner’s investment < capital credit on the date of admission to partnership Amount of bonus = difference Copyright John Wiley & Sons Canada, Ltd. 31 Admission of a Partner: Example Calculation of Bonus Old partners’ capital balance = $120,000 Peart $72,000 and Sampson $48,000 Old partners’ profit ratios: Peart 60% and Huang 40% Trent purchases 25% share: Scenario 2: for $20,000 Copyright John Wiley & Sons Canada, Ltd. 32 Admission of a Partner: Bonus Calculation – Scenario 2 1. Total capital of new partnership: $120,000 + $20,000 = $140,000 2. New partner’s capital credit: $140,000 × 25% = $35,000 3. Amount of bonus to new partner: $20,000 − $35,000 = $(15,000) 4. Allocate bonus from old partners: From Peart: $15,000 × 60% = $9,000 From Huang: $15,000 × 40% = $6,000 Copyright John Wiley & Sons Canada, Ltd. 33 Withdrawal of a Partner Voluntary withdrawal: Partner sells their equity in the firm Involuntary withdrawal: Partner reaches mandatory retirement age, dies or is expelled Withdrawal may be accomplished by: Payment from remaining partners’ personal assets Payment from partnership assets Copyright John Wiley & Sons Canada, Ltd. 34 Withdrawal of a Partner: Payment from Partners’ Personal Assets A personal transaction between partners Payment is from remaining partners’ personal assets Partnership assets are not involved and total capital of partnership does not change In the partnership, only the transfer of the partnership interest is recorded: Departing partner’s equity is eliminated Remaining partners’ equity increased by same amount Amount is split between remaining parties on same basis as they paid departing party Copyright John Wiley & Sons Canada, Ltd. 35 Withdrawal of a Partner: Payment from Partnership Assets A transaction between the withdrawing partner and the partnership: Partnership pays assets in exchange for the withdrawing partner’s interest in the partnership Both net assets and total partners’ equity of the partnership will decrease Complications occur when amount paid differs from withdrawing partner’s capital balance: The difference is considered a bonus either to the departing partner or to the remaining partners Copyright John Wiley & Sons Canada, Ltd. 36 Withdrawal of a Partner: Determining Amount of Bonus 1. Determine the amount of the bonus = Payment from partnership to departing partner ± departing partner’s capital balance If payment > capital balance: bonus to departing partner If payment < capital balance: bonus to remaining partners 2. Allocate payment of bonus to remaining partners based on their profit ratios Amount allocated to each remaining partner = bonus × profit ratio for each partner Copyright John Wiley & Sons Canada, Ltd. 37 Withdrawal of a Partner: Bonus to Withdrawing Partner Bonus to withdrawing partner may be necessary: Fair value of partnership assets may be greater than their carrying amount Goodwill may exist that has not been recorded Remaining partners wish to remove partner from firm Bonus to withdrawing partner occurs when: Payment to departing partner > departing partner’s capital balance on the date of departure Amount of bonus = difference Copyright John Wiley & Sons Canada, Ltd. 38 Withdrawal of a Partner: Example Calculation of Bonus Partners’ capital balance: Roman $50,000 Sand $30,000 Terk $20,000 Partners’ profit ratio: Roman, Sand, Terk: 3:2:1 Terk retires and is paid: Scenario 1: $25,000 Copyright John Wiley & Sons Canada, Ltd. 39 Withdrawal of a Partner: Bonus Calculation Scenario 1: 1. Amount of bonus: $25,000 - $20,000 = $5,000 2. Allocate payment of bonus by remaining partners: From Roman: $5,000 × 3/5 = $3,000 From Sand: $5,000 × 2/5 = $2,000 Copyright John Wiley & Sons Canada, Ltd. 40 Withdrawal of a Partner: Bonus to Remaining Partners Bonus to remaining partners may be necessary: Recorded assets are overvalued Partnership has a poor earnings record Partner wishes to leave partnership Bonus to remaining partners occurs when: Payment to departing partner < departing partner’s capital balance on departure date Amount of bonus = difference Copyright John Wiley & Sons Canada, Ltd. 41 Withdrawal of a Partner: Example Calculation of Bonus Partners’ capital balance: Roman $50,000 Sand $30,000 Terk $20,000 Partners’ profit ratio: Roman, Sand, Terk: 3:2:1 Terk retires and is paid: Scenario 2: $16,000 Copyright John Wiley & Sons Canada, Ltd. 42 Withdrawal of a Partner: Bonus Calculation Scenario 2: 1. Amount of bonus: $16,000 − $20,000 = $(4,000) 2. Allocate payment of bonus to remaining partners: To Roman: $4,000 × 3/5 = $2,400 To Sand: $4,000 × 2/5 = $1,600 Copyright John Wiley & Sons Canada, Ltd. 43