partnership accounting

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Module 9: Accounting for partnerships and corporations

Overview

In previous models, you studied accounting for sole proprietorships. In this module, you learn about partnerships and corporations. Several important legal differences distinguish these three forms of business organizations, and each form has significant advantages and disadvantages. Accountants provide services to all types of organizations, so you must understand their unique characteristics.

For the most part, accounting for these three different types of business entities is the same. The asset and liability section of the balance sheets are identical, as are the income statements.1_{The differences are in how each type of business accounts} for the equity of its owners, known as owner’s equity for a sole proprietorship, partners’ equity for a partnership, and shareholders’ equity for a corporation.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.

Learning objectives

9.1 List the characteristics of a proprietorship and a partnership, and explain the importance of mutual agency and unlimited liability in a partnership. (Level 2)

9.2 Allocate partnership earnings to partners (a) on a stated fractional basis, (b) in the partners’ capital ratio, and (c) through the use of salary and interest allowances. (Level 1)

9.3 Explain the advantages, disadvantages, and organization of corporations. (Level 2)

9.4 Explain the differences in the financial statements for corporate and unincorporated organizations. (Level 1)

9.5 Record the issuance of shares. (Level 1)

9.6 State the differences between common and preferred shares, and allocate dividends between common and preferred shares. (Level 2)

9.7 Record cash dividends and explain their effects on the assets and shareholders’ equity of a corporation. (Level 2)

9.8 Calculate book value per share and interpret and apply this ratio in decision-making scenarios. (Level 2)

9.9 Record share dividends, share splits, and retirement of shares, and explain their effects on the assets and shareholders’ equity. (Level 2)

9.10 Calculate earnings per share for companies with simple capital structures and interpret and apply this ratio in decision-making scenarios. (Level 2)

9.11 Explain how the income effects of discontinued operations are reported. (Level 2)

9.12 Describe restrictions of retained earnings and accounting changes, and the disclosure of such items in the financial statements. (Level 2)

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9.13 Explain the ethical issues around management incentive plans. (Level 1) Module summary

Print this module

1_{Corporations usually include a provision for income tax expense whereas proprietorships and partnerships} do not.

Assignment reminder

Assignment #3 is due this week (see Course Schedule). Please allocate time to complete and submit the assignment by the deadline.

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Module 9 Test your knowledge

1. Total shareholders’ equity is $800,000. $100,000 of this total is 10,000 preferred shares. There are 100,000 common shares authorized; 50,000 common shares issued, of which 48,000 shares are outstanding. What is the book value per common share?

1. $14.00 2. $14.58 3. $16.00 4. $16.67

2. A corporation’s articles of incorporation establish the total number of shares that may be issued. What is the term applied to these shares?

1. Outstanding shares 2. Issued shares 3. Common shares 4. Authorized shares

3. When a corporation issues common shares, what account are they credited to? 1. Current asset account

2. Intangible asset account 3. Long-term investment account 4. Equity account

4. What are shares that carry voting rights called? 1. Preferred shares

2. Voting shares 3. Common shares 4. Contributed capital

5. The retained earnings account had a debit balance of $3,000 at the beginning of 2010. During 2010, net income totalled $12,000 and dividends of $8,000 were paid. During 2011, no dividends were paid and an economic slowdown caused the business to lose $25,000. What was the balance of the retained earnings account at the end of 2011?

1. $18,000 2. $18,000 deficit 3. $24,000

4. $24,000 deficit Solutions

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9.1 Characteristics of proprietorships and partnerships

Learning objective

List the characteristics of a proprietorship and a partnership, and explain the importance of mutual agency and unlimited liability in a partnership. (Level 2)

Required reading

Chapter 14, pages 694-699

LEVEL 2

Proprietorship

A proprietorship is a business owned by one person, while a partnership is an association of two or more persons to operate an unincorporated business for profit as co-owners. From an accounting perspective, proprietorships and partnerships must comply with the business entity

principle that requires that business records must be kept separate and distinct from owners’ personal records. From a legal perspective, proprietorships and partnerships are extensions of their owners. Neither the proprietorship nor the partnership is subject to income taxes; rather, the individuals are required to report their share of income from these businesses on their respective tax returns.

Advantages and disadvantages of a proprietorship

The primary advantage of a proprietorship is the ease with which it can be legally started with only a limited number of legal filing requirements. As stated above, a proprietor is required to keep adequate records for determining income, which is then taxable in the hands of the proprietor. The advantage of ease of ownership is counteracted by disadvantages that include the following:

● Limited life: Upon the death of the proprietor, the business entity ceases.

● Unlimited liability: The proprietor is liable for all debts of the proprietorship to the full extent of his or her personal

wealth.

● Difficulty of ownership transfer: Selling the business to another party may be more difficult than selling a

corporation.

Partnership

Individuals entering into a business partnership should seek accounting and legal advice before they start a business. CGAs in public practice often provide their expertise to a new partnership by advising on financial and tax matters and reviewing the partnership contract to ensure that it addresses unforeseen events. The partners should enter into a partnership agreement that sets out the terms under which the affairs of the partnership will be conducted. This document should be prepared by their legal counsel.

The text describes the characteristics of general partnerships on pages 695-697.

Textbook activities

● Checkpoint Questions 1 and 2 on

page 697 (Solutions on page 717)

● Quick Study 14-1 and 14-2 on page 721

(Solutions)

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equity. There is no distinction between contributed and earned capital when accounting for partnerships and proprietorships because the categories are combined. Proprietorships employ one capital account and one withdrawals account. The capital account is credited for owner investments and accumulated profits. The withdrawals account is closed to the capital account at the end of each accounting period.

Accounting for partnerships is explained on page 698 of the text.

Textbook activities

● Checkpoint Question 3 on page 699

(Solution on page 717)

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9.2 Division of partnership earnings

Allocate partnership earnings to partners (a) on a stated fractional basis, (b) in the partners’ capital ratio, and (c) through the use of salary and interest allowances. (Level 1)

LEVEL 1

Nature of partnership earnings

Profits and losses arising from the operation of a business may be shared in any manner that the partners agree on.

Typically, the partnership agreement stipulates how profit/losses are to be shared. The basis for profit/loss sharing is usually based on a formula that takes into consideration the time and money each partner invests in a partnership. The profit sharing may include a salary allowance; the allowance is a distribution of earnings, not an expense.

Accounting for the division of income is explained on pages 699-703 of the text.

Textbook activities

● Checkpoint Questions 4 to 6 on

● Quick Study 14-4, 14-5, and 14-6 on

page 721 (Solutions)

● Mid-Chapter Demonstration

Problem on pages 705-707

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9.3 Corporate organization

Explain the advantages, disadvantages, and organization of corporations. (Level 2)

LEVEL 2

A corporation is a legal entity incorporated under federal or provincial laws such as the Canada

Business Corporations Act (CBCA) or the

Business Corporations Act of a particular province. The

characteristics of the corporate form and the process for organizing a company are described on pages 734-739.

Textbook activities

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9.4 Corporate financial statements

Explain the differences in the financial statements for corporate and unincorporated organizations. (Level 1)

Note: Delete section titled “Statement of Retained Earnings” on page 740 and replace with the reading titled “Statement of

Changes in Equity” below.

LEVEL 1

Income statement

The basic difference between the income statement of a corporation and that of an unincorporated business is the inclusion of income tax expense, as highlighted in Exhibit 15.3 on page 739. Also, if the owner works for the corporation and is paid a salary, then the amount earned would be expensed, not charged to the proprietor or partner’s capital account.

Statement of comprehensive income (non-examinable)

Entities are required to report comprehensive income. This requirement primarily applies to companies with complex financial arrangements. Comprehensive net income is the total of net income and other comprehensive income. Other comprehensive income includes items not covered in this course, such as unrealized gains and losses on translation of financial statements of self-sustaining foreign operations, unrealized gains and losses on foreign currency hedges, and unrealized gains and losses on financial assets that are available for sale. The starting point for the computation of comprehensive income is net income computed in the same manner as before. This statement is non-examinable.

Statement of changes in equity

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7_{FRS 2009, IAS 1} _{, para. 10 and para. 106-110}

Source: Larson and Jensen, Fundamental Accounting

Balance sheet

The equity section on the balance sheet is called Owner’s Equity and Partners’ Equity for sole proprietorships and

partnerships respectively. For corporations, the equity section is labelled Shareholders’ Equity or simply Equity. As explained above, the types of activities summarized in the equity section are identical regardless of the type of business organization — owner investment, net income and losses, and distribution of net income (withdrawals or dividends). Refer to Exhibit 15.5 on page 741, which contrasts the balance sheet of a sole proprietorship with that of a corporation.

On the corporate balance sheet, shareholders’ equity is composed of two main categories: contributed capital and retained earnings.

● Contributed capital is the portion of a corporation’s equity that represents investments in the company by its

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● Retained earnings is the portion of a corporation’s equity that represents its cumulative net income less

net losses and dividends.

LEVEL 2

Contributed surplus

Contributed surplus is a third category (see page 794 in Chapter 16). The text uses the term “contributed capital from retirement of common shares.” “Contributed surplus from retirement of common shares” is an alternate term with the same meaning. This category will be explained in more detail in Topic 9.9.

Accumulated other comprehensive income (non-examinable)

Accumulated other comprehensive income is a fourth category in shareholders’ equity. Accounting for accumulated other comprehensive income is beyond the scope of this

course and is covered in FA3 . This category is non-examinable.

Textbook activities

● Checkpoint Questions 2, 3, and 5 on

page 741 (Solutions on pages 756-757)

● Quick Study 15-3 to 15-7 on pages

764-765 (Solutions)

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9.5 Issuance of shares

Record the issuance of shares. (Level 1)

LEVEL 1

Sale of shares

A company acquires assets to earn profits for the owners. These assets are collectively paid for with a combination of debt and equity. The primary reason that a company sells shares is to raise money to invest in assets. Sometimes, however, a company uses the proceeds to pay down debt. Shares can be issued for cash, other noncash assets, or services. Selling shares for cash is the norm.

Authorized, issued, and outstanding shares

A corporation normally authorizes the distribution of an unlimited number of shares. However, a company may choose to place a limit on the number of shares it issues, including this maximum in its articles of incorporation. Some provincial jurisdictions require that the corporate charter authorize the maximum number of shares that may be issued, rather than allowing for an unlimited amount.

Make sure you can differentiate between the terms “authorized,” “issued,” and “outstanding”:

● Authorized refers to the number of shares a corporation is permitted to issue. ● Issued refers to the number of shares sold that have not yet been cancelled.

● Outstanding refers to the number of shares that have been issued and are still held by shareholders.1

Exercise 15-1 on page 768 compares the entries between a partnership and a corporation. Solution

Note that there are important differences in the types of accounts used for a partnership and a corporation. For a partnership, any cash distribution is made through the partners’ withdrawal accounts, whereas a cash distribution from a corporation uses a dividend account. Observe that the Income summary account for a partnership is closed to the partners’ Capital accounts, while the Income summary account for a corporation is closed to the Retained earnings account. (Closing entries for a corporation is covered in Topic 9.7.) Also note in the previous exercise that for both a partnership and a corporation, a credit of $96,000 would have been recorded in the Income summary account when the revenue and expense accounts were closed for the year. (See Topic 3.5 for a review of closing entries.)

Textbook activities

● Checkpoint questions 6 and 7 on

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1_{The number of issued and outstanding shares will usually be the same. The only time they differ is when} the firm holds treasury shares, described in Appendix 16A, pages 811-813. This is infrequent, as treasury shares are no longer allowed by the CBCA. The topic of treasury shares is beyond the scope of this

course and is non-examinable.

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9.6 Classes of shares and special features of preferred shares

State the differences between common and preferred shares, and allocate dividends between common and preferred shares. (Level 2)

Chapter 15, pages 744-747 and 750-754

LEVEL 2

The Canada Business Corporations Act

(CBCA) does not distinguish between common and preferred shares. The Act, however, does allow for more than one class of shares. Because of the predominant usage of the terms “common” and “preferred” to distinguish classes of shares, this terminology is used throughout the text and these module notes.

Common shares

Common shares are known as the residual class because common shareholders’ claims to assets and profits of a business

rank behind those of creditors and preferred shareholders. The five basic rights of the common shareholder are summarized in Exhibit 15.10 on page 746.

Preferred shares

A company may issue nonvoting shares,known as preferred shares.1_{Preferred shares differ from common shares in terms} of the rights and privileges related to dividends, liquidation, and conversion. Preferred shares usually include a preference for payment of dividends and for distribution of assets in liquidation. The dividend preference simply means that preferred shareholders are entitled to dividends before common shareholders.

Preferred dividends are generally limited to a fixed amount and must be paid to preferred shareholders before common

shareholders receive dividends. Preferred shareholders are usually less concerned with growth in the future earning potential of the company than common shareholders because preferred dividends are generally fixed in amount and do not vary with earnings. The equity section on the balance sheet or accompanying notes discloses the dividend as a stated amount per share or as a percentage of the issue price. Refer to Exhibit 15.8 on page 745, where the dividend preference per preferred share is $3.

Study the format of the shareholders’ equity section of the balance sheet presented in Exhibit 15.8. Note that it is classified and shows preferred shares and common shares under the heading Contributed capital.

Special features of preferred shares

Much like bonds, preferred shares are governed by an agreement between the corporation and investor. This contract can make provision for any number of terms; some of the more common ones are described on pages 750-754.

Textbook activities

● Quick Study 15-10 on page 766 (Solution)

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Problem on pages 747-748.

Remember to record the issuance of shares that are exchanged for noncash assets and services.

1_{Preferred shares sometimes have voting privileges, usually in narrowly defined circumstances such as} default under the terms of the preferred indenture. This footnote regarding preferred shares is provided for information only and is non-examinable.

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9.7 Cash dividends and closing entries for a corporation

Record cash dividends and explain their effects on the assets and shareholders’ equity of a corporation. (Level 2)

Chapter 15, pages 749-750 and 754-755

LEVEL 2

Cash dividends

Determining when a company should pay a dividend and how much it should pay is beyond the

scope of this course . A corporation faces two practical considerations when

considering paying a dividend:

1. Is it legally permitted to pay a dividend?

Most provinces prohibit the paying of cash dividends unless a corporation has a sufficient credit balance in its retained earnings account. For corporations incorporated under the Canada Business

Corporations Act , a corporation is not permitted to declare or pay dividends if

a. The corporation is, or would after the payment be, unable to pay its liabilities as they become due, or b. The realizable value of the corporation’s assets would thereby be less than the aggregate of its liabilities and

stated capital of all classes.

2. Does it have the money to pay the dividend?

A company may have sufficient retained earnings but little or no available cash. Recall that retained earnings are a component of shareholders’ equity that reflects retained profitability. It is entirely possible to have a large balance in this account, but little cash, because the company reinvested its profits in other assets such as inventory and

equipment.

A company is not obligated to declare dividends. The decision to declare dividends is the board of directors’ responsibility. Once a cash dividend has been declared, however, it becomes a binding obligation, and, as such, it is necessary to record a liability. The manner in which this obligation is recognized is set out on page 749. Note that on the declaration date,

Dividends declared (a temporary contra equity account) is debited and Dividends payable (a current liability account) is credited.1_{Alternatively, Retained earnings may be debited directly instead of Dividends declared.}

Closing entries for a corporation

The closing entries for a corporation are based on the same principles as for a sole proprietorship and partnership. The difference is into which account the income summary and the distribution of income (either as withdrawals or as dividends) are closed. The closing process for a sole proprietorship and a corporation are contrasted in Example 9-1.

Textbook activities

page 752 and question 14 on page 755

(Solutions on page 757)

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766-767 ( Note: For Quick Study 14 to 15-16, in part b for each, replace

“ Prepare a statement of retained

earnings ” with “ Prepare a

statement of changes in equity .” The part

b solutions for each of Quick Study 15-14 to 15-16 are shown below)

● Demonstration Problem on pages

757-759 (NOTE: Replace part 2 of the required with “Prepare statements of changes in equity for the years ended December 31, 2011 and 2012.” The revised solution to part 2 is shown below).

Review the “Required” and “Planning the Solution” closely before attempting the question. Ingraining this process of determining what is required and how to approach the problem through repetition will serve you well when you write your final examination.

Part b solutions to Quick Study 15-14 to 15-16:

Quick Study 15-14, Part b solution:

PETER PUCK INC. Statement of Changes in Equity

For Year Ended May 31, 2011 Preferred

Shares Common Shares Retained Earnings Total Equity

Balance, June 1 $ 7,000 $ 13,000 $ 29,000 $ 49,000

Issuance of shares -0- -0-

-0-Net income (loss) 34,000 34,000

Dividends (3,500) (3,500)

Balance, May 31 $ 7,000 $ 13,000 $ 59,500 $ 79,500

NOTE: Because no shares were issued during the year ended May 31, 2011, the “Issuance of shares” line in the Statement of Changes in Equity could be omitted.

MORRIS INC.

Statement of Changes in Equity For Year Ended November 30, 2011

Preferred Shares Common Shares Retained Earnings Total Equity

Balance, December 1 $ 10,000 $ 48,000 $ 42,000 $ 100,000

-0-Net income (loss) (9,000) (9,000)

Dividends (14,000) (14,000)

Balance, November 30 $ 10,000 $ 48,000 $ 19,000 $ 77,000

NOTE: Because no shares were issued during the year ended November 30, 2011, the “Issuance of shares” line in the Statement of Changes in Equity could be omitted.

VELOR LTD.

Statement of Changes in Equity For Year Ended August 31, 2011

Preferred

Shares Common Shares Retained Earnings/(Deficit) Total Equity

Balance, September 1 $ 10,000 $ 48,000 $ 12,000 $ 70,000

-0-Net income (loss) (18,000) (18,000)

Dividends -0-

-0-Balance, August 31 $ 10,000 $ 48,000 $ (6,000) $ 52,000

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Part 2 solution to Demonstration Problem:

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9.8 Book value per share

Calculate book value per share and interpret and apply this ratio in decision-making scenarios. (Level 2)

Appendix 15A, pages 760-761

LEVEL 2

Book value per share measures shareholders’ equity on a per share basis and represents the worth of each share if the

company were to be liquidated, based on balance sheet values. As balance sheet amounts are based on cost and not current values, the book value per share provides little practical information.

Note:

Appendix 15A on pages 760-761 demonstrates how book value per share is calculated. Pay particular attention to Exhibit 15A.4 on page 761, where cumulative dividends in arrears are deducted from common shareholder equity to determine the book value per share.

Textbook activities

● Judgement Call on page 762 (Solution on page 762)

● Quick Study 15-17 on page 768 (Solution)

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9.9 Additional share transactions

Record share dividends, share splits, and retirement of shares, and explain their effects on the assets and shareholders’ equity. (Level 2)

LEVEL 2

Share dividends

Paying cash dividends requires cash that the company may not have. A company with good investment opportunities may prefer to reinvest its cash assets in future expansion projects. Therefore, a company may decide to distribute a dividend in the form of shares. This is known as a share dividend (or stock dividend ); it increases the number of shares

outstanding. Accounting for this form of dividend is illustrated on pages 789-791.

Exercise 16-1 on page 817 shows the effect of a share dividend on contributed capital and retained earnings. Notice that the total amount of shareholders’ equity does not change.

Solution

Share splits

A share split (or stock split ) occurs when a company issues more than one new share for each share previously

outstanding. In a two-for-one split, each existing shareholder would own twice as many shares as before the split. However, because all shareholders receive a proportionate increase, their percentage ownership remains the same.

Accounting for share splits is explained on page 792.

Exercise 16-2 on page 817 shows the effect of a share split on shareholders’ equity. In particular, notice the effect the share split has on the amount of shares outstanding.

Solution

Textbook activities

(Solutions)

Repurchase of shares

Companies frequently buy back their own shares and retire them. Why? Perhaps a company has surplus cash and sees its own stock as the best investment it can make, or it may want to improve earnings per share (EPS). Whatever the reason, when a company repurchases its own shares for immediate retirement, all capital items related to the shares are removed from the accounts. The difference between the average price the shares were sold for, and the price paid to re-acquire them,

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results in a gain or a loss. This gain or loss flows directly to equity — it is never recorded on the income statement. Accounting for the redemption (or repurchase) of shares is outlined on pages 793-794.

Textbook activities

(Solutions)

Problem on pages 795-797

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9.10 Earnings per share

Calculate earnings per share for companies with simple capital structures and interpret and apply this ratio in decision-making scenarios. (Level 2)

Chapter 16, pages 797-800 (Note: The section titled “Earnings Per Share and Extraordinary Items” on pages 801-802 and all subsequent references to extraordinary items have been omitted. Extraordinary items are not recognized under IFRS).

LEVEL 2

The earnings per share (EPS) figure conveys how much of a company's earnings "belong" to each outstanding common share. Earnings that "belong" to or are available to common shareholders is net income for the year less the amount that must be paid to preferred shareholders for the current year.

EPS is a widely followed and quoted financial performance statistic that public companies report on their income statement.

Companies with simple capital structures

The outstanding share capital of companies with a simple capital

structure consists solely of common shares, or common and non-convertible preferred shares. Public companies with a simple capital structure report basic EPS. The computation of basic EPS is outlined on pages 797-800. Public companies with capital structures that are not simple (known as complex capital structures) will be covered in FA3 .

Textbook activities

● Checkpoint Questions 5, 6, and 7 on

● Quick Study 16-5 to 16-10 on pages

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9.11 Reporting income

Explain how the income effects of discontinued operations are reported. (Level 2)

The following reading replaces pages 802-804 of Chapter 16 in the textbook.

LEVEL 2

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9.12 Retained earnings

Describe restrictions of retained earnings and accounting changes, and the disclosure of such items in the financial statements. (Level 2)

The following reading replaces pages 805-807 of Chapter 16 in the textbook.

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Reinforcement activities

Question 1

Answer the questions about each of the following items related to a company's activities for the year:

1. After using an expected useful life of seven years and no residual value to depreciate its office equipment over the preceding three years, the company decided early this year that the equipment would last only two more years. How should the effects of this decision be reported in the current financial statements?

2. An account receivable in the amount of $180,000 was written off two years ago. It was recovered this year. The president believes this should be reported as an error. How should the proceeds be reported in the current year's financial statements?

Solution:

1. This change in the predicted useful life is a change in an accounting estimate. The current year depreciation should be modified to reflect the change and be reported on the income statement as part of income from continuing operations.

2. This is not an error. It should be treated as a normal recovery of an account previously written off. Therefore, it does not impact the current income statement or prior retained earnings. The recovery affects only balance sheet accounts.

Source: Larson and Jensen, Solutions Manual to

Fundamental Accounting Principles , 13th

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Question 2:

Barton Inc. changed the method of calculating depreciation on its equipment from straight-line to double-declining-balance during 2011. The cumulative effect of the change is an additional expense of $46,000 related to prior years. The tax benefit is $13,000. Record the entry on December 31, 2011.

Solution:

2011

Dec. 31 Retained Earnings 33,000

Income Tax Payable 13,000

Accumulated Depreciation, Equipment 46,000

To record change in method of calculating depreciation. Replace the Demonstration Problem

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9.13 Ethics — Insider trading

Explain the ethical issues around management incentive plans. (Level 1)

ERH , Unit A8, “Making moral choices ‘good enough’ for real-life circumstances”

LEVEL 1

Throughout this course, full-disclosure and fairness in reporting have been emphasized. Accountants have a responsibility to ensure that financial reports are designed not to deceive stakeholders. Consider the following case. Then refer to ERH , Unit A8, to apply a method of thinking through ethical choices when analyzing this case.

Falcon Corporation’s board of directors and officers have been meeting to discuss and plan the agenda for the corporation’s 2008 annual shareholders’ meeting. The first item considered by the directors and officers was whether to report a large government contract that Falcon has just obtained. Although this contract will significantly increase income and cash flows in 2008 and beyond, management decided that there is no need to reveal the news at the shareholders’ meeting. “After all,” one officer said, “the meeting is intended to be the forum for describing the past year’s activities, not the plans for the next year.”

After concluding that the contract will not be mentioned, the group moved on to the next topic for the shareholders’ meeting. This topic is a motion for the shareholders to approve a compensation plan that will award the managers the rights to acquire large quantities of shares over the next several years. According to the plan, the managers will have a three-year option to buy shares at a fixed price that equals the market value of the shares as measured 30 days after the upcoming shareholders’ meeting. In other words, the managers will be able to buy shares in 2009, 2010, or 2011 by paying the 2008 market value. Obviously, if the shares increase in value over the next several years, the managers will realize large profits without having to invest any cash. The financial vice-president asks the group whether they should reconsider the decision about the

government contract in light of its possible relevance to the vote on the share option plan.

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Module 9 summary

Accounting for partnerships and corporations

List the characteristics of a proprietorship and a partnership, and explain the importance

of mutual agency and unlimited liability in a partnership.

● A sole proprietorship has one owner.

● A partnership is an association between the partners (two or more owners) to operate a business for profit. ● All partners in a general partnership are personally liable for all the debts of the partnership.

● The risk of becoming a partner results in part from the fact that partnership characteristics include mutual agency

and unlimited liability.

❍ Mutual agency means that you are responsible for your partner’s actions.

❍ The partners are jointly and severally liable for all debts incurred by the partnership. Each of the partners has

unlimited liability.

Allocate partnership earnings to partners (a) on a stated fractional basis, (b) in the

partners’ capital ratio, and (c) through the use of salary and interest allowances.

● A partnership’s net income or losses are allocated to the partners according to the partnership agreement.

● The agreement may specify that each partner will receive a given fraction, or that the allocation of income and losses

will reflect salary allowances and/or interest allowances.

● When salary and/or interest allowances are granted, the residual net income or loss is usually allocated equally or on

a stated fractional basis.

Explain the advantages, disadvantages, and organization of corporations.

● Advantages of the corporate form of business include ❍ separate legal entity

❍ limited liability ❍ continuity

❍ no mutual agency ● Disadvantages include

❍ strict government regulations

❍ corporations are subject to various taxes that other business entities are not, including income taxes

Explain the differences in the financial statements for corporate and unincorporated

organizations.

● The equity section on the balance sheet is called “owner’s equity” and “partners' equity” for sole proprietorships and

partnerships respectively. For corporations, the equity section is labelled “shareholders’ equity.”

● Shareholders’ equity consists of ❍ contributed capital ❍ retained earnings

Record the issuance of shares.

● When shares are issued, the proceeds are credited to a share capital account which forms part of contributed capital.

State the differences between common and preferred shares, and allocate dividends

between common and preferred shares.

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● Common shares are known as the residual class because common shareholders’ claims to assets and profits of a

business rank behind those of creditors and preferred shareholders.

● Preferred shares differ from common shares in terms of the rights and privileges related to dividends, liquidation, and

conversion.

● Preferred dividends are generally limited to a fixed amount and must be paid to preferred shareholders before

common shareholders receive dividends.

Record cash dividends and explain their effects on the assets and shareholders’ equity of

a corporation.

● A company is not obligated to declare dividends. The decision to declare dividends rests with the board of directors. ● Once a cash dividend has been declared, it becomes a legal obligation and a liability must be established.

● Cash dividends transfer corporate assets to the shareholders, reducing a company’s assets and equity.

Calculate book value per share and interpret and apply this ratio in decision-making

scenarios.

● Book value per share measures shareholders’ equity on a per share basis based on balance sheet values.

● As balance sheet amounts are based on cost as opposed to current values, the book value per share provides little

practical information.

Record share dividends, share splits, and retirement of shares, and explain their effects

on the assets and shareholders’ equity.

● A share dividend occurs when a company makes a pro rata distribution of additional common shares to existing

shareholders.

● A share split occurs when a company issues more than one new share for each share previously outstanding. ● For both share dividends and share splits, because all shareholders receive the same proportionate increase in

shares, their percentile ownership of the company remains unchanged.

● Neither a share dividend nor a share split affect assets or total shareholder equity. ● Share dividends transfer monies from retained earnings to share capital.

● When a company repurchases its own shares for immediate retirement, all capital items related to the shares are

removed from the accounts. The gain or loss flows directly to equity.

Calculate earnings per share for companies with simple capital structures and interpret

and apply this ratio in decision-making scenarios.

● Earnings per share (EPS) conveys how much of a company’s earnings "belong" to each outstanding common share. ● Earnings that "belong" to or are available to common shareholders is net income for the year less the

amount that must be paid to preferred shareholders for the current year.

● EPS is calculated by dividing net income less dividends to preferred shares by the weighted-average number of

common shares outstanding.

Explain how the income effects of discontinued operations are reported.

● Discontinued operations are the operations of a business segment that has been sold, abandoned, shut down, or

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❍ The net income or loss from operating the segment and the gain or loss on disposal are separately reported

on the income statement below income from continuing operations and are reported net of tax.

Describe restrictions of retained earnings and accounting changes, and the disclosure of

such items in the financial statements.

● Retained earnings can be restricted so as to inform shareholders that the full amount of retained earnings is not

available for distribution by way of dividends.

● Restrictions are disclosed in the notes to the financial statements. ● Accounting changes include:

❍ changes in accounting policy or principle, which require retroactive restatement of financial statements

A change in accounting policy occurs when an entity adopts a policy different from the one previously used. In order for users of the financial statements to understand the effects of a change in accounting policy:

■ previous year’s results must normally be restated, and ■ the nature and justification for the change must be disclosed

❍ correction of errors in prior financial statements, which requires restatement of the prior year’s financial

statements, but has no effect on the current year’s operating results

❍ change in estimate, which is accounted for in period of change and future

Explain the ethical issues around management incentive plans.

● Management may desire to prepare misleading financial reports to ensure that they receive performance-based

bonuses.

● Accountants have a responsibility to ensure that financial reports are designed not to deceive stakeholders.

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Module 9 Test your knowledge solutions

a.

1. Incorrect. ($800,000 – $100,000) ÷ 50,000 = $14.00; however, the denominator is supposed to be based on the number of common shares outstanding (48,000) and not the number of common shares issued.

2. Correct. The book value per common share is $14.58, calculated as $800,000 – $100,000 = $700,000 ÷ 48,000 outstanding common shares = $14.58.

3. Incorrect. $800,000 ÷ 50,000 = $16.00; however, the $100,000 contributed capital belonging to the preferred shareholders was not subtracted in the numerator. Also the denominator should be based on the number of common shares outstanding (48,000) and not the number of common shares issued.

4. Incorrect. $800,000 ÷ 48,000 = $16.67; however, the $100,000 contributed capital belonging to the preferred shareholders was not subtracted in the numerator.

b.

1. Incorrect. Outstanding shares are shares that have been issued and are actually held by shareholders. 2. Incorrect. Issued shares are shares that have been sold.

3. Incorrect. Common shares have voting rights and are held by the residual owners of a corporation.

4. Correct. Authorized shares is the term applied to the total number of shares that may be issued as established by the corporation’s articles of incorporation.

c.

1. Incorrect. Common shares issued by a corporation are not recorded by that corporation as current assets. 2. Incorrect. Common shares issued by a corporation are not recorded by that corporation as intangible assets. 3. Incorrect. Common shares issued by a corporation are not recorded by that corporation as part of a long-term

investment account.

4. Correct. Common shares issued by a corporation are recorded by that corporation as an equity account. d.

1. Incorrect. Preferred shares do not have voting rights.

2. Incorrect. Voting shares is not the term normally used to describe shares with voting rights. 3. Correct. Common shares have voting rights.

4. Incorrect. Contributed capital is a category in Shareholders’ equity on a corporate balance sheet. e.

1. Incorrect. The balance was a deficit rather than a credit balance.

2. Incorrect. $3,000 + $12,000 – $8,000 – $25,000 = ($18,000) deficit. However, the $3,000 beginning balance should be subtracted and not added because it is a debit balance.

3. Incorrect. The balance was a deficit rather than a credit balance.

4. Correct. The balance of the Retained earnings account at the end of 2011 was a $24,000 deficit, calculated as – $3,000 + $12,000 – $8,000 – $25,000 = – $24,000.

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Exercise 15-1 solution

a. Suppose Tom and Joan’s company is organized as a partnership, the following entries would be prepared to record the business start-up and its operations:

b. Suppose the company is organized as a corporation that issued 1,000 common shares, the following entries would record the business start-up:

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3.5 Closing entries

Prepare closing entries for a service business. (Level 1)

LEVEL 1

Accounts are either permanent or temporary in nature. Balance sheet accounts are permanent accounts, while income statement accounts are temporary.

Permanent accounts are continuous accounts — their balances are carried forward from one

accounting period to the next. Using cash as an example, the cash account balance fluctuates during the accounting period as deposits and payments are made. The ending cash balance from one period becomes the beginning cash balance for the next period; therefore, the account continues from one period to the next.

Temporary accounts are periodic accounts , and at the end of each accounting

period, their balances are closed (transferred) to owner’s equity. The revenue account, for example, is a temporary account. The revenue account for each accounting period begins with a zero balance.

Closing entries transfer the balances in the temporary accounts (revenue, expense, and withdrawals accounts) to a balance

sheet equity account (owner’s capital for a sole proprietorship). The closing process is described and illustrated on pages 196-201. Work through the example in Exhibits 5.10 to 5.13 and check your understanding of the subject.

Textbook activity

● Quick Study 5-5 to 5-7 on pages 220-221

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Example 9-1

Note that if cash dividends are debited directly to the Retained earnings account (instead of being debited to the Cash dividends declared account), there is no need to close the Cash dividends declared account.

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1 _{This account is a contra equity account; it is not} _{a liability.}

2 _{Share dividends are recorded using the market/fair value on the date of declaration.}

3 _{Notice that no assets are being distributed to the shareholders as a result of a share dividend, unlike a cash dividend where} cash, an asset, is distributed to shareholders.

Analysis component:

The market price of Delware’s shares decreased as a result of the 5% share dividend because given that the number of shares issued and outstanding increased with no additional asset investment by shareholders, the value will decrease per share (assuming no changes other than the share dividend). Since the share price is recovering after the declaration of the share dividend (as evidenced by the market price increase from January 20 to January 30 of $13.50 to $14.25), it can be assumed that shareholders have a positive future outlook for this company.

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Analysis component:

The market price of Stingray’s shares decreased by about 2/3 as a result of the 3:1 share split because although the number of shares tripled, no new assets were contributed by the shareholders as a result of the share split. If the number of shares triples with no assets contributed, it is logical that the market value per share would decrease by a ratio equivalent to the increase in the number of shares.

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Analysis

A reasonable approach to this case is to start by identifying the facts and the operational issues. The facts are clearly stated in the case. It is important to recognize, however, the conflict between the managers’ fiduciary responsibility to the

shareholders and their apparent desire to increase their personal wealth through the share option plan. If the information about the new contract can be kept private until after the option plan is approved and the options are priced, the managers will stand to make much more money when they eventually exercise those options. The officer’s suggestion that annual meetings are only about the company’s past activities is misleading because shareholders are being asked to vote on the three-year stock option plan for managers. Moreover, the general point of annual meetings is to provide an opportunity for the board to be accountable to shareholders.

This case raises both legal and moral issues. It is against the law to mislead the capital markets by distributing false

information or by withholding relevant information. The managers’ decision to withhold the news is objectionable because of the share option plan. The financial vice-president should impress upon the officers and directors that withholding

information about the contract would be unethical.

Some economists and philosophers argue that rules against insider trading don’t work and that markets would be more efficient if there were no prohibitions of insider trading. So while there would not be a level playing field for investors (insider investors would know far more than investors on the outside), the market would respond more quickly and efficiently to new information and the rest of the market would learn the information quickly. Moreover, these critics claim that with no rules against insider trading, other investors (outsiders) would factor in their relative lack of knowledge in making investment decisions by hiring more knowledgeable investment experts, for example.

It is important to realize that the argument about which type of market arrangements would be more efficient — one with restrictions on insider trading and one with no restrictions — is a theoretical one. It is

not an argument that under our current arrangements (which strongly restrict insider trading), it is acceptable to act in violation of the securities regulations and to take advantage of “uninformed” investors, who trust that investments will generally be made on the basis of publicly available knowledge.

You can rightly argue that rules against insider trading should be weakened or even abolished. But it is definitely wrong to engage in insider trading in a market that has rules against it. This is to take unfair advantage of others. This is like driving on the left-hand side of the road in Canada and justifying this by claiming that it is required to drive on that side in Japan. In other words, it is one thing to argue about whether one set of rules is more desirable than another, but quite another to act on that belief when the general rule in place is the opposite.

For human interactions (including economic interactions) to work well, we have to agree on certain ground rules and trust that they are in place. Once the ground rules are in place (whether these permit or forbid insider trading), it is unfair to act as if those rules do not exist. Moreover, to act in such an unfair way undermines the trust that makes productive human interactions possible.

The ethical bottom line in this case is then crystal clear. The managers are acting unethically in withholding this information from the shareholders, and they are undermining the trust that is essential to capital markets.