© Pearson Education, Inc. publishing as Prentice Hall15-1 Chapter 15: Partnerships – Formation,...

© Pearson Education, Inc. publishing as Prentice Hall 15-1

Chapter 15: Partnerships – Formation, Operations, and

Changes in Ownership Interestsby Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany

Advanced Accounting, 10th editionby Floyd A. Beams, Robin P. Clement,

Joseph H. Anthony, and Suzanne Lowensohn


Partnerships: Objectives

1. Comprehend the legal characteristics of partnerships.

2. Understand initial investment valuation and record keeping.

3. Grasp the diverse nature of profit and loss sharing agreements and their computation.

4. Value a new partner's investment in an existing partnership.


Objectives (cont.)

5. Value a partner's share upon retirement or death.

6. Understand limited liability partnership characteristics.


1: Characteristics of Partnerships1: Characteristics of Partnerships

Partnerships – Formation, Operations, and Changes in Ownership Interests


Partnerships

RUPA "Revised Uniform Partnership Act"– Entity theory:

• partners own their share of the partnership, but not its individual assets

– Dissociation: • partners can dissociate without dissolution

Partners have – Mutual agency– Unlimited liability


Articles of Partnership

1. Products or services, line of business2. Partner rights & responsibilities3. Initial investment and value assigned to

noncash investments4. Additional investment conditions5. Asset withdrawals6. Profit and loss sharing7. Dissolution procedures


Partnership Reporting

• Financial reporting should provide for the needs of– Partners– Creditors of the partnership– IRS


2: Initial Investment2: Initial Investment



Initial Investment

A partnership is started by Amy and Paul, each investing cash.

If they invest other assets, the value of those assets should be agreed upon in advance.

Cash XXX Amy Capital XXX

Cash XXX Paul Capital XXX

Cash XXX Equipment XXX

Land XXX Paul Capital XXX


Initial Investment with Bonus or GoodwillPartner initial investments, at fair value, will not

represent their ownership.– Individual talent– Business connections– Customer base

Partners choose method– Bonus method

• Adjustment within the capital accounts– Goodwill method

• Goodwill is recorded on the books


Initial Investment with BonusTotal fair value received is split, as desired,

between partnersCola invests land and building worth $10 and $40.Crown invests cash and inventory at $7 and $35.Agree to have equal shares:

(10 + 40 + 7 + 35) / 2 = $46 eachCash 7 Inventory 35

Land 10 Building 40

Cola Capital 46

Crown Capital 46


Initial Investment with Goodwill

Cola's 50%(100) $50He invests: Land $10 Building $40

$50

Crown's 50%(100) $50He invests: Cash $7 Inventory $35 $42Goodwill $8

If Cola and Crown agree to equal shares, use larger implied total value of firm.

Cola's: (10 + 40) / 50% = $100Crown's: (7 + 35) / 50% = $84

Implied value of firm $100


Initial Entry with Goodwill

Land 10 Building 40

Cola Capital 50

To record Cola's investment

Cash 7

Inventory 35

Goodwill 8

Crown Capital 50

To record Crown's investment and goodwill


Partner Accounts

Each partner has his/her own accounts for– Capital– Drawings (periodic, salary-like, amounts)– Withdrawals (other, large, unusual amounts)

• Investments increase Capital• Drawings and withdrawals are closed to Capital• Income Summary or Revenue and Expense

Summary is closed to Capital.


Sample Partner Closing EntriesAmy Capital XXX

Amy Drawings XX

Amy Withdrawals XX

Reduces Amy's capital for drawings and withdrawalsPaul Capital XXX

Paul Drawings XXX

Income Summary Profit

Amy Capital XXX

Paul Capital XXX

To share profits between Amy and Paul

Drawings / withdrawals are closed to individual capital accounts.

Income is shared between the partners. A loss would cause the entry to be reversed. It is possible for some partners to have losses while other have profits.


Statement of Partners' Capital

Beginning capital + investments – drawings and/or withdrawals + income or – loss = ending capital


3: Sharing Profit and Loss3: Sharing Profit and Loss



Profit/ Loss Sharing Agreements

The partnership articles should clearly state the means of distributing profits and distributing losses.

Items commonly considered– Bonus allowance– Salary allowance – Interest allowance on capital invested

• Based on average, beginning or ending capital balance

– Sharing of remaining amounts


Bonus and Salary Allowances

Bonus allowances are often based on partnership profits and may be before or after:

(a) salary allowances and (b) bonus.If the bonus is after both:

Bonus = b% x (NI – Salary Allow – Bonus)

Salary allowances are generally pre-determined amounts


Interest Allowances and Capital

Interest Allowances are generally based on a measure of the partner's capital– Beginning of the year capital balance– Average* capital balance for the year

Weighted average balance– Ending* capital balance

Beginning balance – withdrawals + investments* Periodic drawings are often ignored, although

withdrawals are considered


Allocating Income

Partner's allowances for bonus, salary and interest are allocated to them, whether or not sufficient profits exist.

Remaining profits (or deficit) is then split according to the agreed-upon proportions.

These are general procedures. The partnership articles provide the specific requirements.


Example: Sharing Profits

Tom and Betty agree to share profits and losses:• Tom and Betty have $60 and $30 salary allowances• Betty has a bonus of 50% of profits in excess of $500• Each have interest allowances of 10% of beginning

capital– Tom Capital, 1/1 $400– Betty Capital, 1/1 $350

• Remaining profits or losses are shared Tom 60%, Betty 40%.

Partnership profits are $660 for the year.


Share Profits of $660

Bonus = 50%(660 - 500) = 80Tom Interest = 10%(400) = 40Betty Interest = 10%(350) = 3560%(415) = 249; 40%(415) = 166

Total Tom BettyNet income $660 Salary allowance (90) $60 $30 Bonus allowance (80) 0 80 Interest allowance (75) 40 35 Subtotal $415 Split 60:40 (415) 249 166 Allocated net income $0 $349 $311


Share Profits of $180Assume instead that income was only $180.

Bonus = zero, income does not exceed thresholdTom Interest = 10%(400) = 40Betty Interest = 10%(350) = 3560%(-45) = -27; 40%(-45) = -18

Total Tom BettyNet income $120 Salary allowance (90) $60 $30 Bonus allowance 0 0 0 Interest allowance (75) 40 35 Subtotal, deficit ($45) Split 60:40 45 (27) (18)Allocated net income $0 $73 $47


4: Admitting a New Partner4: Admitting a New Partner



Admitting a New Partner

1. A current partner assigns interest to new partner.

2. New partner purchases interest from existing partner.• Goodwill method• Bonus method

3. New partner invests directly in partnership.• Goodwill method• Bonus method


Assignment

Assignment gives the assignee right to a share of future earnings and share of assets in liquidation– Not a partner– No share in management

Old Partner Capital XXX

Assignee Capital XXX


Buy from Partner: Simple

Alfano and Bailey have capital balances of $50 each and each have a 50% interest in the firm.

Cobb buys half of Alfano's interest for $25.

Before After

Capital Share Capital Share

Alfano $50 50% $25 25%Bailey 50 50% 50 50%Cobb 25 25%Total $100 $100

Alfano Capital 25

Cobb Capital 25


Buy from Partner: Goodwill

Don and Ed have capital of $50 and $40 with each 50% interest.

Fay will pay $60 directly to the partners and receive 50% interest in the firm. Don and Ed each keep 25%. Assets are at fair value.

The goodwill increases Don & Ed's capital each by $15.

Implied value of firm, $60/.50 120 Old capital, $50 + 40 90 Goodwill 30


Goodwill Revalues Capital

Presumably, Fay paid $35 to Don and $25 to Ed.If the partners had not wanted to realign the

capital, the capital of Don and Ed would each be reduced by $30 to transfer the $60 to Fay.

Before RevaluationAfter

revaluation Transfer FinalDon $50 $15 $65 ($35) $30 Ed 40 15 55 (25) 30 Fay 60 60

Total $90 $120 $120


Buy from Partner: Bonus

If Don and Ed had decided not to revalue the assets or record goodwill, the bonus method is used.

Fay's capital is 50%(90) = $45.Don and Ed Capital accounts are adjusted to their

new balances 25%(90) = $22.5

Before Transfer FinalDon $50 ($27.5) $22.5 Ed 40 (17.5) 22.5 Fay 45.0 45.0

Total $90 $90.0


Entries for Purchase from PartnerEntries for Fay's admission, under goodwill and

bonus methods:Goodwill 30

Don Capital 15

Ed Capital 15

Don Capital 35

Ed Capital 25

Fay Capital 60Goodwill method, aligning capital accountsDon Capital 27.5

Ed Capital 17.5

Fay Capital 45Bonus method, aligning capital accounts


Invest in Business: GoodwillAndrew and Boyles have capital balances of $40

and $40 and share equally in the firm.Criner will be admitted with an investment of $50

cash. All three will have equal shares. Net assets are at fair value; goodwill will be recorded.

Implied value of firm, $50/(1/3) $150 Old capital, $40 + 40 $80 Additional investment 50 130 Goodwill $20 Criner: $130*1/3 = $43.3, but he pays $50 … so goodwill goes to old partners.Implied firm value is based on Criner's investment.


Investment and Goodwill Add to Capital (Goodwill to Old Partners)

Capital of $80 at the start, increases by the $20 goodwill and the $50 cash investment.

BeforeRevalu-ation

After re-valuation Investment Final

Andrew $40 $10 $50 $50 Boyles 40 10 50 50 Criner $50 50

Total $80 $100 $150


Invest in Business: GoodwillAndrew and Boyles have capital balances of $40

and $40 and share equally in the firm.Criner will be admitted with an investment of $50

cash. Criner will be given a 40% share; Andrew and Boyles will each have 30%. Net assets are at fair value; goodwill will be recorded.

Implied value of firm, $80/(.60) $133.3Old capital, $40 + 40 $80 Additional investment 50 130.0 Goodwill $3.3 Criner: $130*40% = $52, but he pays $50 … so goodwill goes to new partner. Implied firm value is based on old partners' capital and retained interest.


Investment and Goodwill Add to Capital (Goodwill to New Partner)

Capital of $80 at the start, increases by the $3.3 goodwill and the $50 cash investment.

BeforeRevalu-ation

After re-valuation Investment Final

Andrew $40 $40 $40.0

Boyles 40 40 40.0 Criner $3.3 3.3 $50 53.3

Total $80 $83.3 $133.3


Invest in Business: Bonus

Andrew and Boyles decide not to revalue the business assets, and Criner invests $50 cash in the business for a 1/3 interest.

Criner's new capital = 1/3 of the total $130. Since he invests on $50 cash for a $52 interest, the $2 bonus is transferred from the old partners.

Before Investment Bonus Final

Andrew $50 ($1) $49

Boyles 40 (1) 39Criner $50 2 52

Total $90 $130


Entries for Investment in BusinessEntries for Criner's investment, under goodwill

and bonus methods:Goodwill 20

Andrew Capital 10

Boyles Capital 10

Cash 60

Criner Capital 60Goodwill method, goodwill to old partnersCash 50

Andrew Capital 1

Boyles Capital 1

Criner Capital 52

Bonus method, bonus to new partner


5: Death or Retirement of a Partner5: Death or Retirement of a Partner



DissociationFirm value, according to RUPA, is the greater of

– Liquidation value– Sales value as a going concern without the dissociated

partnerPayment to exiting partner is

– Equal to existing capital– More than existing capital

• Implied goodwill or bonus to exiting partner– Less than existing capital

• Write down overvalued assets, or bonus to remaining partners


6: Limited Liability Partnership6: Limited Liability Partnership



Limited Partnerships

Limited partnerships must have one or more general partners

Limited partner– Excluded from participating in management– Limited liability– Partnership agreement

• In writing, signed and filed


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