Chapter Fourteen

Partnerships: Formation and

Operation

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Partnerships

A partnership is defined as “an association of two or more persons to carry on a business as co-owners for profit.” (Section 6 of Uniform Partnership Act).

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The IRS projects that by 2016, nearly 4.7 million partnership U.S. income tax returns will be filed, compared to 8.1 million corporation income tax returns. (Source: www.irs.gov)

Learning Objective 14-1

Explain the advantages anddisadvantages of the partnershipversus the corporate formof business.

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Partnership Advantages

Advantages: Flexibility in defining relationships Profits and losses, and management operating decisions,

shared independent of ownership percentages. Ease of formation and dissolution. Taxes “flow-through” to the partners.

Disadvantages: Unlimited liability incurred by each partner (they are

“jointly and severally” liable). Mutual agency (each partner has right to incur liabilities

in the name of the partnership). Inability to participate in various corporate tax benefits

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Alternative Legal Forms - Subchapter S Corporation

Legal characteristics of a corporation.

Ownership limited to 100 stockholders.

Owners limited to individuals, estates, and certain tax-exempt entities and trusts (no corporate owners allowed).

Profit passes to owners as a partnership.

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Alternative Legal Forms

Limited partners not allowed to participate in management.Losses are restricted for limited partners to the amount invested.Must have one or more general partners who assume responsibility for all obligations.

Limited Partnership (LP)

Owners: Risk their own investments.Are responsible for contractual debts of the business.Are liable only for their own acts and omissions, and those of individuals they directly supervise.

Limited Liability Partnership (LLP)

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Alternative Legal Forms – Limited Liability Company (LLC)

LLC’s are a new type of organization for U.S.

They have long been used in Europe and other areas.

They are classified as partnerships for tax purposes.

In contrast to Sub Chapter S Corporations, the number of owners is not usually restricted.

Owners only risk their own investments.

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Partnerships - Capital Accounts

The equity section of a partnership consists of capital balances for each partner.

Profits/losses for each period are allocated to each partner’s capital account.

Withdrawals by partners reduce their capital accounts.

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Learning Objective 14-2

Describe the purpose of thearticles of partnership and listspecific items that should beincluded in this agreement.

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Articles of Partnership

The Uniform Partnership Act establishes standards and rules for partnerships but a written agreement will supersede the UPA standards.

Articles of partnership should always clearly describe the:

• Name and address of each partner.

• Business location.

• Nature of the business.

• Rights and responsibilities of each partner.

• Initial contribution to be made by each partner and the method to be used for valuation.

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Articles of Partnership

Articles of partnership should always clearly describe the:• Specific method by which profits and losses are to be

allocated.• Periodic withdrawal of assets by each partner.• Procedure for admitting new partners.• Method for arbitrating partnership disputes.• Life insurance provisions enabling remaining partners to

acquire the interest of any deceased partner.• Method for settling a partner’s share in the business

upon withdrawal, retirement, or death.

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Learning Objective 14-3

Prepare the journal entryto record the initial capitalinvestment made by a partner.

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Accounting for Capital Contributions

Assume that Carter and Green form a business to be operated as a partnership. Carter contributes$50,000 in cash and Green invests $20,000. The initial journal entry to record the creation of the partnership:

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Accounting for Capital Contributions

If one or more of the partners transfers noncash assets, fair value is used to record the assets. Assume that Carter invests $50,000 in cash to begin the previously discussed partnership and Green contributes the following assets

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Accounting for Capital Contributions

Green’s building is encumbered by a $23,600 mortgage that the partnership has agreed to assume. Green’s net investment is equal to $43,400 ($67,000 less $23,600). The following journal entry records the formation of the partnership created by these contributions

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Learning Objective 14-4

Use both the bonus methodand the goodwill methodto record a partner’s capitalinvestment.

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Accounting for Capital Contributions

Contributed intangible assets require special consideration .

Contributions made by one or more of the partners may go beyond assets and liabilities, for example, a particular line of expertise or established clientele.

Use either the Bonus Method or Goodwill Method for recording contributed intangible assets.

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Intangible Contributions - Example

James and Joyce open an advertising agency and organize as a partnership.

James contributes cash of $70,000, and Joyce invests only $10,000. Joyce, however, is an accomplished graphic artist, a skill that is considered especially valuable to this business.

James and Joyce have contributed a total of $80,000 in identifiable assets to their partnership and have decided on equal capital balances.

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Intangible Contributions - Bonus Method Example

The bonus method simply splits the $80,000 capital evenly between the two partners. Joyce received a capital bonus of $30,000 (the $40,000 recorded capital balance in excess of the $10,000 cash contribution) from James in recognition of her artistic abilities she contributed.

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Intangible Contributions - Goodwill Method Example

The goodwill method is based on the assumption that an implied value can be calculated mathematically and recorded for any intangible contribution made by a partner.

In the present illustration, Joyce invested $10,000 cash, $60,000 less than James, but receives an equal amount of capital according to the partnership agreement.

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Intangible Contributions - Goodwill Method Example

Joyce’s artistic talent has an apparent value of $60,000, a figure that should be included as part of this partner’s capital investment. If not recorded, Joyce’s primary contribution to the business is ignored completely within the accounting records.

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Learning Objective 14-5

Demonstrate the impact thatthe allocation of partnershipincome has on the partners’individual capital balances.

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Allocation of Income

Partnership revenues and expenses must be closed out at the end of each fiscal period and the net income allocated to each partners’ capital account.

A method must be devised for assignment of income.

Articles of partnership should stipulate an established procedure.

If no arrangement is specified, state partnership laws dictate that all partners receive an equal allocation of income or loss.

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Allocation of Income -- Example

Assume that Tinker, Evers, and Chance form a partnership by investing cash of $120,000, $90,000, and $75,000, respectively.

Evers will be allotted 40 % of all profits and losses because of previous business experience. Tinker and Chance are to divide the remaining 60 % equally. This agreement also stipulates that each partner is allowed to withdraw $10,000 in cash annually from the business.

Net income for the period is $60,000.

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Allocation of IncomeExample

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Learning Objective 14-6

Allocate income to partnerswhen interest and/or salaryfactors are included.

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Allocation of Income

The allocation of income is not necessarily based on the relative capital balances.

It is a separately negotiated item.

Allocated compensation

Bonuses Remaining income

Interest on beginning capital

balances

Items to be allocated:

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Alternative Technique-1

Assume the original facts for the Tinkers, Evers, and Chance partnership except an articles of partnership agreement credits each partner annually for interest equal to 10 % of that partner’s beginning capital balance for the year.

Evers and Chance will also be allotted $15,000 each as a compensation allowance in recognition of their participation in daily operations.

Any remaining profit or loss will be split 4:3:3, with the largest share going to Evers because of the work experience that this partner brings to the business.

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Alternative Technique- 1

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Alternative Techniques-

The assignment process is merely a series of mechanical steps reflecting the change in each partner’s capital balance resulting from the provisions of the partnership agreement.

The number of different allocation procedures that could be employed is limited solely by the partners’ imagination.

Although interest, compensation allowances, and various ratios are the predominant factors encountered in practice, numerous other possibilities exist.

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Learning Objective 14-7

Explain the meaning ofpartnership dissolution andunderstand that a dissolution will often have little or no effect on the operations of thepartnership business.

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Legal Dissolution

Any alteration in the specific individuals composing a partnership results in “legal dissolution”– Departures– Retirement – Death– Admission (including promotion) of a New Partner– Immediate formation of a new partnership as

business continues– New partner acquires partnership interest by:

Purchasing it from the other partners, ormaking a contribution to the partnership.

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Learning Objective 14-8

Prepare journal entries torecord the acquisition by anew partner of either all or aportion of a current partner’sinterest.

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These two rights can be sold (unless restricted by the

articles of partnership).

This right cannot be sold without the

other partners’ approval.

Admission of a New Partner - The Rights of a Partner

An individual partner’s ownership rights include:

The right to co-ownership in the business property.

The right to share in profits and losses as specified in the partnership agreement

The right to participate in the management of the business.

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Admission of a New Partner - Purchase of a Current Interest

A new partner can purchase partnership interest directly from the existing partners.The cash goes to the partners, not the

partnership.Two methods are available to account for the

transfer of ownership:Book Value ApproachGoodwill (Revaluation) Approach

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Admission of a New Partner - Purchase of a Current Interest

Assume Scott, Thompson, and York formed a partnership, and subsequently, York decides to leave the partnership. He offers to sell his interest to Morgan.

Although York may transfer the right of property ownership as well as the specified share of future profits and losses, the partnership does not automatically admit Morgan.

York legally remains a partner until such time as both Scott and Thompson agree to allow Morgan to participate in the management of the business.

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Admission of a New PartnerPurchase of a Current Interest

Book Value Approach Instead of York selling his interest to Morgan, each of these three partners elects to transfer a 20 percent interest to Morgan for a total payment of $30,000 in a simple capital reclassification. The money is paid directly to the owners.

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Admission of a New Partner - Purchase of a Current Interest

Goodwill Approach

Scott, Thompson, and York is transferring all assets and liabilities to the partnership of Scott, Thompson, York, and Morgan. The goodwill method recognizes the transaction as occurring between two separate reporting entities that necessitates the complete revaluation of all assets and liabilities.

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Learning Objective 14-9

Prepare journal entries torecord a new partner’s admission by a contribution made directly to the partnership.

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Admission of a New Partner - Contribution to the Partnership

The new partner can also gain partnership interest by contributing cash to the partnership.

Remember that the new cash will increase the partnership’s net assets.

Two methods are:Bonus ApproachGoodwill Approach

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Admission of a New Partner - Contribution to the Partnership

An outsider may be admitted to a partnership by contributing directly to the business. Assume King and Wilson maintain a partnership and presently report capital balances of $80,000 and $20,000, respectively.

According to the articles of partnership, King is entitled to 60 % of all profits and losses with the remaining 40% credited each year to Wilson. Goldman can enter the partnership for $20,000 cash with the money going into the business. Goldman receives an initial 10 percent interest in partnership property.

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Admission of a New Partner - Contribution to the Partnership

Bonus Credited to Original Partners

Goodwill Credited to Original Partners

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Admission of a New Partner - Contribution to the Partnership

Hybrid Method

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Admission of a New Partner - Contribution to the Partnership

Bonus or Goodwill Credited to New Partner

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Learning Objective 14-10

Prepare journal entries torecord the withdrawal of acurrent partner.

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Withdrawal of a Partner

The Withdrawing Partner is paid out in accordance with the Partnership Agreement.

Using the Bonus Method, any amount paid in excess of that partner’s capital account is allocated against the remaining partners’ capital accounts.

Using the Goodwill Method, the books are first adjusted to FMV, with a proportion of the increase allocated to each partner’s account. The withdrawing partner is then paid based on the balance in the individual capital account.

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Withdrawal of a Partner

Goodwill Method Applied

Bonus Method Applied

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Withdrawal of a Partner

Hybrid Method Applied

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