Review the available materials for the chapters covered this week, including the lecture, reading, publisher materials, demonstration problems and exercises at the end of the chapters. After reviewing these materials and attempting the assignment for the week, what challenges did you face? Do you have any questions on the material?
Partnerships and Corporations
Introduction
There are three primary forms of organization for a business: the sole proprietorship, the partnership, and the corporation. The corporate form of organization is beneficial for many reasons, but the “principal advantage is its facility for attracting and accumulating large amounts of capital” (Kieso, Weygandt, & Warfield, 2010, p. 726). Through issuing various classes of stock, the corporation can sell ownership interests in the business in exchange for cash or other assets needed by the business. The raising of capital through issuing stock, distribution of profits through payment of dividends, and repurchase of stock as treasury stock are examined in this module.
Partnerships
Partnerships are desirable forms of business organizations for two primary reasons: 1) a partnership structure eliminates the possibility of double taxation which results in higher returns for the partners; 2) the Uniform Partnership Act [1914] (UPA) or the Revised Uniform Partnership Act of 1984 (RUPA), which has been adopted by a large majority of the states, simplifies and standardizes the laws governing partnerships and their business conduct in more than one state. Most states have adopted either UPA or RUPA. When the partnership does not have a formal governing document such as a partnership agreement, or the partnership agreement is silent regarding an aspect of partnership operations, it is governed by the statutory regulations of the state in which it is operating.
Partnership Characteristics and Formation
A partnership may be formed fairly simply and may be a result of an intentional or an unintentional action. As a result of a verbal or written agreement between the parties, a partnership is formed. When two or more parties mutually share in the control and profits of a business, they become partners by association without regard to how they may characterize their relationship. It is therefore usually less complicated to operate a multistate business in the partnership form whether it is a limited partnership or a general partnership. A legally binding partnership can be formed by an oral agreement, making partnerships attractive because of their ease of formation. Alternative forms of organization include the Subchapter-S corporations, limited partnerships, limited liability partnerships, and limited liability companies (Fischer, Taylor, & Chen, 2006).
Partnerships are formed as either a general partnership or a limited partnership. In a general partnership, all partners act as an agent of both the partnership and every other partner. The general partners share in the profits or losses of the entity, the management of the business, and the responsibility for debt of the partnership. The partners are jointly and severely liable for the obligations of the partnership and they have unlimited liability. While a general partner has management rights and responsibilities for entity liabilities, a limited partner’s liability is limited to his/her capital contribution (Jeter et al., 2007).
Because general partners are personally liable for the entity’s debts, a general partnership, to the extent of the general partners’ assets, can ordinarily obtain a greater amount of credit, other things being equal. Conversely, in a limited partnership, the limited partners are not liable to the extent of their assets and are not able to obtain substantial credit. While a general partner has management rights and responsibility for entity liabilities, a limited partner’s liability is limited to their capital contribution and their control in the management of the partnership is extremely limited (Hitchner, 2003).
Although a written partnership agreement is likely to be prepared by an attorney, it is not uncommon for an accountant to be asked to review the agreement and make suggestions. Overall, this request is not within the realm of an accountant’s expertise and he/she should apprise the client that the partnership agreement will be reviewed only with respect to accounting or tax matters such as: 1) the basis of accounting; 2) the year end; or 3) the sharing of profits and losses. For example, the accountant should not advise partners how to share profits and losses. However, the accountant could explain the specifics of a profit and loss sharing formula and provide hypothetical explanations.
Accounting for Partnerships
The greatest difference in accounting for a partnership versus a corporation is the treatment of partner capital. The equity interest of each partner is shown in that partner’s capital account. All of the partner’s contributions to the partnership, the allocation of partnership profits and losses to the partner, and the distribution of partnership assets to an individual partner will be accumulated in the partner’s capital account. The equity section of the partnership’s balance sheet will include each partner’s capital account balance.
Whenever a partner contributes assets to the partnership, this increases the partner’s equity. Contributions are accounted for by increasing the individual partner’s capital account for the fair market value of the asset contributed. To account for partner contributions, an asset account is debited and the partner’s capital account is credited. Partners may also provide services for which they are not paid, and the value of the services may be added to the partner’s capital account in lieu of payment. Rather than debiting an asset account, the expense account that represents the services provided would be debited, and the partner’s capital account credited.
A partner may choose to periodically withdraw assets of the business, usually in the form of cash, for personal use. In addition to a capital account, there will be a drawing account for each partner of the partnership; the drawing accounts are used to track withdrawals of equity made by each partner. The drawing accounts are contra-equity accounts, and thus have a normal debit balance. The drawing accounts therefore act much like a dividend account in a corporation. In a partnership, partners will often take regular withdrawals of cash throughout the period against the anticipated profit allocation that takes place at the end of the period.
Allocation of Profits and Losses
At the inception of a partnership, the partners will determine the method of allocating profits and losses of the partnership to the individual partners. Typical allocation methods include using a predetermined allocation rate or allocating proportionate to the ownership interests of the partners. Profit allocation may be calculated after partners’ salaries or bonuses are paid out. The partnership agreement should specifically stipulate the terms of profit allocation.
Losses are also allocated to individual partner accounts. Losses will decrease each partner’s equity balance. Profits and losses are allocated to the partners during the closing process, whereby all income and expense items are closed out to the respective partner’s equity accounts.
Tax Implications of Partnership Activities
A partnership does not pay taxes at the entity level. Rather, its income or loss is passed through the partnership to the individual partners allocable pro rata according to partnership agreement regarding profit sharing. Since a partnership is not a taxable entity, it will not have net operating loss carrybacks or carryforwards. However, on a partner level, the net amount of an operating loss in a specific year can be carried back for a 3-year period and then it can be carried forward for 7-year period on the partner’s individual income tax returns.
Ownership Changes
A partnership is legally dissolved whenever a partner exits a partnership, or at the discretion of the partners. Upon partnership dissolution, assets are allocated to the partners in accordance with a predetermined dissolution plan that should be included in the original partnership agreement.
Liquidations
When a business organized as a partnership ceases operations, a liquidation of assets must take place and the capital is distributed to the partners. This can be accomplished through a lump sum distribution, whereby a final distribution is issued to the partners in proportion to their capital accounts after the gain or loss on asset sale is recognized, or through installment liquidation, which allows for distributions to the partners as the assets are being liquidated, prior to the final calculation of gain or loss. Installment liquidations require the calculation of safe payments so that one partner does not receive more assets than will ultimately be eligible for distribution after calculation of the gain or loss.
There is little economic difference between the sale of a partnership interest and the liquidation of a partnership interest as a result of liquidating the partnership’s assets. However, the effect from a taxation perspective can be quite different according to which methodology is employed. There are two broad categories of liquidation methodology to consider. They are lump-sum liquidations and installment liquidations, which are defined as 1) lump-sum distribution – a final distribution issued to the partners according to their pro rata capital accounts after the gain or loss are recognized and 2) installment liquidations − distributions issued to the partners prior to recognition of gain or loss.
Corporations
Corporations sell ownership interests in their businesses called stock. The sale of stock is the sale of a portion of the ownership of a business. The funds generated are considered capital funds that can be used for whatever needs the business may have. Companies must incorporate before they are able to participate in business as a stock company. Individual states grant incorporation and are responsible for enacting laws that govern the activity of corporations registered in their jurisdiction.
Ownership of stock carries rights for the investor. The owner of the stock has a right to participate in profits and losses, voting rights in management, proportionate shares in liquidation, and preemptive rights to any new issues of stock (Kieso et al., 2010). The stockholder also has the right to sell their stock at any time and at any price. The sale of stock is generally offered on the public market through stock exchanges. The New York Stock Exchange is the premier example of such an open forum for the sale and purchase of capital stock.
Shares of stock are considered the personal property of the owner. The stockholder receives a distribution of the profits of the business whenever a dividend is declared and paid. As incentive to invest in a company’s stock, the company may set aside all or a portion of profits made during an operating cycle for distribution to stockholders in the form of a dividend. The board of directors of a corporation will declare a dividend, at which time it becomes a legal obligation of the corporation; until a dividend is declared, the stockholders have no guarantee that dividends will be paid for a period. Typically, a corporation will withhold some of the profits of an operating cycle to fund growth and expansion or to meet other funding needs; however, it may also decide to withhold all profits and declare no dividend. Incentive to invest in a company’s stock when no dividends are declared is usually the anticipation that the stock will appreciate in value over time, making the investment worthwhile.
The section of the balance sheet that provides details on stock and owner’s equity is called stockholder’s equity. Three main categories make up this section: 1) capital stock details the volume of capital outstanding, 2) additional paid in capital describes the amount of value the business has accumulated due to sale premiums of stock, and 3) retained earnings details the amount of profit that has been reinvested back into the business venture. Terminology related to the stockholders’ equity section of the balance sheet includes the following:
Par value − nearly all stock is based on a set price, independent of market value, called par value. Par value is the basis of the price of stock, sometimes called its face value since the par value is generally printed on the stock certificate.
No-par value − some stock is sold with no set price. No-par value stock has no face value. No-par value stock avoids several issues related to fair-market value that is inherent in par-value stock.
Stock certificate − most stock has a printed document that is issued to the purchaser. This is evidence of ownership of the stock and determines the unit of ownership and face value of the stock (if par value is used).
Additional paid-in-capital − when stock is purchased from the corporation during an issue period, the stock may be sold at a market value above its face or par value. When this is the case, the amount above the face value of the stock is generally recorded in an account called additional paid-in-capital. This account provides readers of the financial statements the ability to determine what portion of capital investment has come from funding above the face value of stock issued. The additional paid-in-capital account is also used for recording other capital transactions.
Stock also may be released for sale in several classes. Every corporation issues common stock. Common stock carries with it the basic rights of ownership, including voting and preemptive rights. A corporation may decide to sell additional classes of stock. One of these classes is termedpreferred stock. Preferred stock generally has a higher preference for dividend distribution and liquidation funds, but it is more likely to have restrictions that preclude it from other ownership rights. Preferred stock also can include provisions for cumulative dividend payment, participation of dividend distribution in proportion to common stock, and convertibility to common stock.
Dividends
Stock imparts partial ownership of the business to the holder of the stock. The amount of ownership is based on the units of stock owned. The stockholder is entitled to a proportionate share of the profits distributed by the company. The portion received is known as a dividend. At an appropriate time, usually annually, the corporate boards of directors determine an amount of the profits it will share with the stockholders. When the board announces the amount of profits to be shared, they are declaring a dividend. The corporation will reserve dividend funds and release them after a period of time in which stockholders of record are determined. A single unit of stock will receive a dollar amount, normally termed earnings per share. Dividends are normally distributed in cash; however, several additional methods can be used:
Property dividends − the distribution of profits through a form other than cash or additional stock.
Liquidating dividends − the use of additional paid-in-capital. When using additional paid-in-capital as a dividend source you are returning capital to the owners. Such a dividend distribution needs to be documented so investors understand that the dividend funds are investment funds being returned.
Stock dividends − the issuance of additional stock to shareholders in lieu of a cash distribution. A stock dividend permanently capitalizes the profits represented by the dividend. The shareholder receives additional stock, but no cash in such a distribution.
Over time, a corporate stock can increase in value. This is common when long periods of undistributed earnings accumulate. As the stock value climbs on the market, the higher price can squeeze out smaller investors that might otherwise have been able to invest in the corporation. The board of directors may decide to lower the value by splitting the shares of stock. Splitting the stock lowers the value based on the number of shares split. For example, if the stock was worth $50 per share prior to the split and the split were two-for-one, the new value of the stock would be $25 each. After the split is executed, current owners of stock would own twice as many shares as before. No dilution of ownership takes place during a stock split.
Stock Compensation Plans
Key executives are often granted a benefit as part of a stock compensation plan called astock option. Stock options are warrants that give the holder an option to purchase stock at a set price sometime in the future (Kieso et al., 2010). Stock compensation plans are required to be expensed (Kieso et al.). Using the fair-value method, the total compensation expense is calculated based upon the fair value of the options expected to vest as of the grant date, which is expensed over the service period. The fair-value of the options expected to vest can be estimated using an option-pricing model, such as the Black-Scholes option-pricing model (Kieso et al.). On the date the stock options are granted, there is no entry into the accounting records, and for each of the service periods, compensation expense is debited and paid-in capital from stock options is credited. At the time of exercise, cash is debited for the amount of cash received (options exercised multiplied by the exercise price), the paid-in-capital from stock options that was previously accrued is debited, common stock is credited for the par value of the stock issued, and paid-in-capital from common stock is credited for the balance. Expired stock options are recognized by debiting paid-in-capital from stock options and crediting paid-in-capital from expired stock options as of the expiration date.
Earnings per Share
Earnings per Share (EPS) is one of the most widely used measures of evaluating corporate performance. EPS is the ratio of income earned to dollars invested by common stock in the corporation. EPS is reported against common stock only. All other capital classes of stocks are removed from the calculation. The normal value used for common stock is based on a weighted average of all outstanding common stock issued during the reporting period. This method includes the various levels of common stock sold or retired during the accounting cycle. Due to the importance of EPS as a measure of performance throughout the financial industry, the ratio is required on all annual reporting statements.
A number of corporate funding and stock activities can have the potential to dilute the current ratio of ownership of the current shareholders. An example of this is the convertible bonds that might be issued by a corporation. Such a bond has a provision that allows the holder to convert the bond to common stock during a specific period of time. Any conversion that occurs dilutes, or decreases, the ownership of current stockholders. Among the issues that concern the marketplace is the recording and disclosure of such bonds. Other dilutive stock transaction types include the following:
Convertible preferred stock, which like convertible bonds can take a preferred stock class and convert it to a common class.
Stock warrants, which are certificates that give the holder the option to acquire common stock at a future time at a prearranged price.
EPS can be shown on a basic or a fully diluted basis. Fully diluted EPS differs from basic EPS calculations in that rather than comparing earnings to the weighted average number of shares of common stock outstanding, the number of shares is presented on a fully diluted basis, that is, the number of shares of stock is assumed to be the maximum number of shares that could have been outstanding based upon outstanding dilutive securities. Fully diluted EPS shows the most conservative value that EPS could have been for the period.
Treasury Stock
A corporation may repurchase its own stock. The purchase of its own stock may be done to increase EPS of stock, thwart takeover bids, or reduce the tax burden of stockholders. When a corporation purchases its own stock, the repurchased stock becomes known as treasury stock. Treasury stock is not a reduction of the capital stock amount on the balance sheet. Unless the stock is retired, it remains on the books as issued.
Treasury stock can be accounted for using the cost method, or the par (or stated) value method. According to Kieso et al. (2010), both the cost and par value methods are generally accepted. Under the cost method, treasury stock is debited for the reacquisition cost and is reported as a deduction from the total paid-in-capital and retained earnings on the balance sheet; under the par value method, all transactions regarding treasury shares are recorded at par value and treasury stock is a deduction from paid-in-capital only (Kieso et al.).
Conclusion
Capitalization of a corporation is more than raising funds for projects or ongoing business activity. The sale of stock is the sale of ownership in an organization. The stockholders have a vested interest in the growth of the business for personal gain through appreciation of stock value. In addition, the financial press is constantly looking over the shoulder of corporate leadership, using the stock market value of a corporation’s shares as a barometer of successful activity. Due to the importance of the presentation of the stockholders’ equity section of the balance sheet, it is critical that the accountant understand how to properly account for equity-related transactions.
Horngren’s Accounting, The Financial ChaptersRead chapters 12 and 13.
References
Fischer, P. M., Taylor, W. J., & Chen, R. H. (2006). Advanced accounting (9th ed.). Mason, OH: South-Western.
Hitchner, J. R. (2003). Financial valuation applications and models. Hoboken, NJ: John Wiley & Sons.
Jeter, D. C. & Chaney, P. K. (2007). Advanced accounting (3rd ed.). Hoboken, NJ: John Wiley & Sons.
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2010). Intermediate accounting (13th ed.). Hoboken, NJ: John Wiley & Sons.
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