AFAR Notes by CPM

Partnership Basics and Characteristics

A partnership forms when two or more people contribute money, property, or skills to run a business together and share profits. This business structure offers ease of formation since partnerships can be created through either oral or written agreements.

Partnerships have several key characteristics that affect their accounting. They have limited life since major changes like partner admission or withdrawal can dissolve the original partnership. Partners also share unlimited liability, meaning they're personally responsible for partnership debts if business assets aren't enough.

Pro Tip: Pay special attention to partner capital accounts - they're the foundation of partnership accounting and show each partner's ownership stake in the business.

Each partner has both a capital account (showing their ownership stake) and a drawing account (tracking withdrawals). Capital accounts increase with investments and profit shares while decreasing with withdrawals and loss allocations. When partners loan money to the partnership, these are recorded as liabilities, not as capital contributions.

Partnership Formation and Operations

When forming a partnership, cash investments are valued at face value, while non-cash assets need proper valuation. Partners can agree on using either agreed value, fair market value, or carrying value for non-cash contributions. If the partnership agreement is silent about valuation, equal sharing is assumed.

The bonus method is used when a partner's initial investment differs from their agreed capital contribution. This adjustment ensures each partner's capital aligns with their ownership percentage without requiring additional contributions.

During operations, partnerships must allocate net income or losses according to their partnership agreement. The profit and loss ratio (P/L ratio) determines how income or losses are distributed among partners. Typical allocation methods include:

1. Salaries for industrial partners who contribute skills rather than capital
2. Bonuses for managing partners (often as a percentage of net income)
3. Interest on capital balances for capitalist partners

Remember: Salaries, bonuses, and interest in partnerships aren't expenses like in corporations - they're methods of allocating profits among partners.

If a partnership agreement doesn't specify allocation methods, profits and losses are divided equally by default.

Partnership Dissolution

Dissolution happens when there's a change in the partnership structure, such as when partners join or leave. Each partner's capital balance must be updated before dissolution by allocating income/losses and recording any asset revaluation.

When a new partner is admitted, it can happen through:

1. Private transaction - new partner buys interest directly from existing partners (no change in partnership capital)
2. Investment in partnership - new partner contributes assets, increasing total capital

The bonus method applies when a partner's contributed capital (CC) differs from their agreed capital (AC). When CC > AC, existing partners receive the bonus; when CC < AC, the new partner receives it.

Partner withdrawal can occur through:

1. Purchase of interest - remaining partners buy the departing partner's share
2. Settlement by partnership - the partnership pays the departing partner

Important: Always update capital balances whenever dissolution occurs by allocating income/losses and revaluing assets or liabilities.

Partnership incorporation converts the business to a corporate structure, offering advantages like limited liability for owners, ease of raising capital, unlimited life, and easier ownership transfer.

Partnership Liquidation

Liquidation is the final phase of a partnership's life when it terminates operations. The process involves selling all non-current assets, paying creditors, and distributing remaining cash to partners based on their capital balances.

The order of priority for distributing partnership assets is:

1. External creditors
2. Internal creditors (partner loans)
3. Partners' capital balances

Liquidation can occur as either:

• Lump-sum liquidation - completed quickly in a single period
• Installment liquidation - takes time with partial distributions

For installment liquidation, accountants use a Schedule of Safe Payments to determine how much cash can be safely distributed without risking overpayment to any partner. This requires calculating the Maximum Possible Loss by considering:

1. Estimated liquidation expenses
2. Cash withheld for future use
3. Remaining book value of non-cash assets

Critical concept: During installment liquidation, always assume partners with potential deficits will be personally insolvent. These hypothetical deficits must be allocated to remaining partners using their profit and loss ratio.

A Cash Priority Program ranks partners by their vulnerability to losses, with the most vulnerable partner (lowest loss absorption ability) receiving priority in cash distributions.

Corporate Liquidation

Corporate liquidation occurs when a company's debts exceed its assets at fair valuation. Unlike partnerships, corporate bankruptcies follow strict legal procedures and can be either voluntary or involuntary (initiated by creditors).

The Statement of Affairs is a specialized balance sheet prepared when a corporation enters liquidation. It categorizes assets and liabilities based on their security status:

Assets are listed at net realizable value (NRV) and grouped as:

• Assets pledged to fully secured creditors (assets > liabilities)
• Assets pledged to partially secured creditors (assets < liabilities)
• Free assets (unpledged assets)

Liabilities are organized by priority:

1. Fully secured liabilities
2. Partially secured liabilities
3. Unsecured creditors with priority (wages, taxes, legal fees)
4. Unsecured creditors without priority

Key calculation: The recovery percentage for unsecured creditors = Net Free Assets ÷ Total Unsecured Liabilities

The Statement of Realization and Liquidation shows the liquidation progress, tracking:

• Assets to be realized, acquired, realized, and not realized
• Liabilities to be liquidated, assumed, liquidated, and not liquidated
• Supplementary items (income and expenses arising during liquidation)

This statement provides a comprehensive view of the actual transactions occurring during the liquidation period.

Statement of Realization and Liquidation Format

The Statement of Realization and Liquidation organizes information in columns to show the full picture of liquidation activities. The left side lists:

• Assets to be realized
• Assets acquired
• Liabilities liquidated
• Liabilities not liquidated
• Supplementary charges
• Gain

The right side shows:

• Assets realized
• Assets not realized
• Liabilities to be liquidated
• Liabilities assumed
• Supplementary credits
• Loss

A properly formatted Statement of Affairs includes both book values and estimated realizable values for all assets. This statement clearly separates:

• Assets pledged to secured creditors
• Free assets
• Liabilities by security status
• Stockholders' equity

Important distinction: The Statement of Affairs focuses on valuation (what assets and liabilities are worth), while the Statement of Realization and Liquidation tracks activity (what happens to assets and liabilities during liquidation).

The difference between free assets and unsecured liabilities with priority shows the net free assets available for other creditors. When liabilities exceed assets, the statement shows an estimated deficiency to unsecured creditors.

Home Office and Branch Accounting

Businesses establish branches to expand into new markets or decentralize operations. While branches maintain their own accounting records and prepare separate financial statements, they ultimately form a single economic entity with the home office.

The key to branch accounting is handling reciprocal accounts - accounts that appear in both sets of books but must be eliminated when preparing combined financial statements:

• Home office records: Investment in Branch, Shipment to Branch, Allowance for Overvaluation of Inventory
• Branch records: Home Office Equity, Shipment from Home Office

When the home office ships merchandise to branches at a markup, an Allowance for Overvaluation of Inventory (AOI) account tracks the unrealized profit. This unrealized profit becomes realized when the branch sells the goods to external customers.

Critical concept: The branch doesn't know the markup applied by the home office, which is why special elimination entries are needed for combined statements.

Sir Brad's Magic Table helps track transactions between home office and branch:

The true net income of a branch equals its reported net income plus the realized portion of AOI. Combined net income equals the home office net income plus the true net income of all branches.

Branch Accounting Journal Entries

Branch accounting requires precise journal entries to track transactions between home office and branches. For each transaction, both the home office and branch must make corresponding entries to maintain balanced books.

When cash transfers from home office to branch, the home office debits Investment in Branch and credits Cash, while the branch debits Cash and credits Home Office Equity. Similarly, when merchandise transfers at cost, the home office debits Investment in Branch and credits Shipment to Branch, while the branch debits Shipment from Home Office and credits Home Office Equity.

For merchandise transferred above cost, the home office creates an Allowance for Overvaluation account to track the markup. This allowance is considered realized when the branch sells the merchandise, adjusting the reported branch net income.

Important calculation: To convert from billed price to cost, use this formula: Cost = Billed price ÷ (100% + % markup on cost)

When recording branch profit, the home office debits Investment in Branch and credits Branch Income, while the branch debits Income Summary and credits Home Office Equity. Conversely, for branch losses, the home office debits Branch Loss and credits Investment in Branch.

For companies with multiple branches, the home office maintains separate investment accounts and allowance accounts for each branch, with separate worksheet adjustments for each branch's operations.

Cost Accounting Basics

Cost accounting focuses on measuring, recording, and reporting product costs to determine both total and per-unit costs. Accurate unit costs are crucial since they form the basis for setting selling prices (unit cost + markup).

Companies typically use one of two cost accounting systems:

1. Job Order Costing - for small volume, unique products (heterogeneous) like custom buildings or jewelry
2. Process Costing - for large volume, identical products (homogeneous) in mass production like paper or automobiles

The basic formula for unit cost is: Total Manufacturing Costs ÷ Number of Good Units

Job order costing typically follows these journal entry steps:

1. Purchase raw materials (debit RM Inventory, credit Accounts Payable)
2. Use materials in production (debit WIP, credit RM Inventory)
3. Record direct labor (debit Work-in-Process, credit Salaries Expense)
4. Record actual overhead costs (debit OH Control, credit various accounts)
5. Apply overhead to production (debit WIP, credit OH Applied)

Pro Tip: Most companies use normal costing (actual direct costs + applied overhead) rather than actual costing for practical reasons.

At year-end, compare actual overhead (OH Control) with applied overhead. The difference is either underapplied (actual > applied) or overapplied (applied > actual). Material differences are allocated to WIP, Finished Goods, and COGS based on their relative balances.

Accounting for Spoiled Units

Spoiled units are products that can't be sold at their original price due to quality issues. These units create accounting challenges since their costs must be properly allocated.

Spoilage is classified as either:

• Normal spoilage - within expected parameters
• Abnormal spoilage - exceeding expected rates

Additionally, spoilage can be:

• Specific spoilage - due to customer specifications (charged to that customer)
• Common spoilage - due to internal failures (charged to all units)

When spoilage is charged to the entity (internal failure), the journal entry is:

Spoiled goods (at NRV)     xxx
MOH (Loss)                 xxx
   WIP                         xxx

The loss is charged to manufacturing overhead as an actual overhead cost.

Remember: The treatment of spoiled goods directly impacts your unit cost calculations, so identify whether spoilage is charged to the customer or to all production.

When spoilage is charged to a specific customer, the journal entry is:

Spoiled goods (at NRV)     xxx
   WIP                         xxx

Here, the loss is included in the costs transferred to finished goods.

The unit cost formula changes based on how spoilage is handled. For common spoilage, exclude the cost of spoiled units from the cost transferred to finished goods. For specific spoilage, subtract only the NRV of spoiled goods.