Beams ch16 partnership

to accompany

Advanced Accounting, 11th edition

by Beams, Anthony, Bettinghaus, and Smith

Chapter 16

Partnerships –

Formation, Operations,

and Changes in

Ownership Interests

Copyright ©2012 Pearson Education,

Inc. Publishing as Prentice Hall16-1



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.

5. Value a partner's share upon

retirement or death.

6. Understand limited liability

partnership characteristics.

Partnerships: Objectives (cont.)



1: PARTNERSHIP

CHARACTERISTICS

Partnerships – Formation, Operations, and

Changes in Ownership Interests



Partnerships

RUPA "Revised Uniform Partnership Act“ Has been adopted by most states Entity theory: partners own their share of the partnership, but

not its individual assets Dissociation: partners can dissociate without dissolution of the

partnershipPartners have Mutual agency – the ability to legally bind the

partnership Unlimited liability – liable for partnership debts,

including the use of personal assets



Articles of Partnership

The partnership agreement should

specify:

1. Products or services, line of business

2. Partner rights and responsibilities

3. Initial investment and value assigned

to noncash investments

4. Additional investment conditions

5. Asset withdrawals

6. Profit and loss sharing

7. Dissolution procedures



Partnership Reporting

Financial reporting should provide for the

needs of

Partners

Creditors of the partnership

IRS – partnerships do not pay federal

income taxes, but partnership tax returns

allow the IRS to verify that each partner pays

income taxes on their share of partnership

income

2: INITIAL INVESTMENT







Initial Investment

If Paul invests 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

A partnership is started by Amy and Paul, each

investing cash.



Bonus or Goodwill on Initial Investment

Partner initial investments may not represent

ownership percentage. Partners may bring

Individual talent

Business connections

Customer base

Intellectual know-how

Partners choose method to record their capital

Bonus method

Adjustment within the capital accounts

Goodwill method

Goodwill is recorded on the books



Initial Investment with Bonus

Total fair value received is split, as desired,

between partner capital accounts.

For example: Amy invests land and building

worth $10 and $40, and Paul invests cash and

inventory at $7 and $35. They agree to have

equal shares: (10 + 40 + 7 + 35) / 2 = $46 eachCash 7

Inventory 35

Land 10

Building 40

Amy Capital 46

Paul Capital 46



Initial Investment with Goodwill

The partner contributing the greater fair value

sets the implied value of the partnership, and

goodwill is recorded to make up the difference

for the partner who invested the lesser amount.

In the Amy and Paul partnership:

Amy's: (10 + 40) / 50% = $100

Paul's: (7 + 35) / 50% = $84

Use Amy’s investment to determine implied

value of firm -- $100.



Initial Entry with Goodwill

Land 10

Building 40

Amy Capital 50

To record Amy's investment

Cash 7

Inventory 35

Goodwill 8

Paul Capital 50

To record Paul's investment and goodwill

Amy's 50%($100) $50

She invests:

Land $10

Building $40 $50

Paul's 50%($100) $50He invests:

Cash $7Inventory $35 $42

Goodwill $8



Additional Partner Transactions

Each partner has his/her own accounts for

Capital (the balance of a partner’s equity)

Drawings (periodic amounts, similar to a salary)

Withdrawals (other large or unusual amounts)

Additional investments increase Capital.

Drawings and withdrawals reduce Capital.

Income Summary (Revenue and Expense

Summary) is closed to Capital.



Sample Partner Closing EntriesAmy Capital XXX

Amy Drawings XX

Amy Withdrawals XXReduces Amy's capital for drawings and withdrawals

Paul 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 overall while others have profits.



Statement of Partners' Capital

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

3: PROFIT AND LOSS

SHARING AGREEMENTS







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, provided to partners who

manage the partnership. Salary allowances are

not expenses in the determination of

partnership net income.



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 yearWeighted average balance

Ending* capital balanceBeginning balance – withdrawals + investments

* Periodic drawings are often ignored, although

withdrawals are considered



Allocating Income

Partners’ allowances for bonus, salary and

interest are allocated to them, whether or not

sufficient profits exist.

Remaining profits (or deficit) are then split

according to the agreed-upon proportions.

These are general procedures. The partnership

articles provide the specific requirements.



Example: Sharing ProfitsLot and Babel agree to share profits and losses:

Lot and Babel have $60 and $30 salary

allowances, respectively

Babel has a bonus of 50% of profits in excess

of $500

Each have interest allowances of 10% of

beginning capital

Lot Capital, 1/1 $400

Babel Capital, 1/1 $350

Remaining profits or losses are shared Lot 60%,

Babel 40%

Partnership profits are $660 for the year.



Example: Sharing Profits (cont.)

Bonus = 50%(660 - 500) = 80

Lot Interest = 10%(400) = 40

Babel Interest = 10%(350) = 35

Allocation: 60%(415) = 249; 40%(415) = 166

Total Lot Babel

Net 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



Assume instead that income was only $180.

Total Lot Babel

Net 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

Example: Sharing Profits (cont.)

Bonus = zero (income does not exceed $500)Lot Interest = 10%(400) = 40Babel Interest = 10%(350) = 35

Allocation: 60%(-45) = -27; 40%(-45) = -18

4: ADMITTING A NEW

PARTNER







Admitting a New Partner

There are three methods of entry for a new

partner into an existing partnership:

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 the 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

Note that this means one partner can not make

the decision to admit a new partner into the

partnership, only to legally assign the financial

rights of ownership.



Buy from Partner: Simple

Abby and Bing have capital balances of $50

each and each have a 50% interest in the firm.

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

Before After

Capital Share Capital Share

Abby $50 50% $25 25%

Bing 50 50% 50 50%

Cobb 25 25%

Total $100 $100

Abby Capital 25

Cobb Capital 25



Buy from Partner: Goodwill

Dawn and Ed have capital of $50 and $40, each

with 50% interest.

Fay will pay $60 directly to the partners and

receive 50% interest in the firm. Dawn and Ed

each keep 25%. Assets are at fair value.

The goodwill increases Dawn & Ed's capital by

$15 each.

Implied value of firm, $60/.50 120

Old capital, $50 + 40 90

Goodwill 30



Buy from Partner: Goodwill (cont.)

Presumably, Fay paid $35 to Dawn and $25 to Ed.

If the partners had not wanted to realign the

capital, the capital of Dawn and Ed would each be

reduced by $30 to transfer the $60 to Fay.

Before RevaluationAfter

revaluation Transfer Final

Dawn $50 $15 $65 ($35) $30

Ed 40 15 55 (25) 30

Fay 60 60

Total $90 $120 $120



Buy from Partner: Bonus

If Dawn and Ed had decided not to revalue the

assets or record goodwill, the bonus method is

used.

Fay's capital is 50%(90) = $45.

Dawn and Ed Capital accounts are adjusted to

their new balances 25%(90) = $22.5

Before Transfer Final

Dawn $50 ($27.5) $22.5

Ed 40 (17.5) 22.5

Fay 45.0 45.0

Total $90 $90.0



Entries for Purchase from Partner

Entries for Fay's admission, under goodwill

and bonus methods:Goodwill 30

Dawn Capital 15

Ed Capital 15

Dawn Capital 35

Ed Capital 25

Fay Capital 60

Goodwill method, aligning capital accounts

Dawn Capital 27.5

Ed Capital 17.5

Fay Capital 45

Bonus method, aligning capital accounts



New Partner Investment:

Goodwill to Old Partners

Al and Bev each have capital balances of $40 and share equally in the firm. Cal will be admitted with an investment of $50 cash.

All three will have equal shares, and 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

Cal: $130*1/3 = $43.3, but he pays $50 … so goodwill goes to old partners. Implied firm value is based on Cal's investment.



Capital of $80 at the start, increases by the

$20 goodwill and the $50 cash investment.

BeforeRe-valuation

After re-valuation Investment Final

Al $40 $10 $50 $50

Bev 40 10 50 50

Cal $50 50

Total $80 $100 $150

New Partner Investment: Goodwill to Old Partners (cont.)



Al and Bev each have capital balances of $40 and share equally in the firm. Cal will be admitted with an investment of $50 cash.

Cal will be given a 40% share; Al and Bev will each have 30%, and net assets are at fair value. Goodwill will be recorded.

Implied value of firm, $80/(.60) $133.3

Old capital, $40 + 40 $80

Additional investment 50 130.0

Goodwill $3.3

Cal: $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.

New Partner Investment: Goodwill to New Partner



Capital of $80 at the start, increases by the

$3.3 goodwill and the $50 cash investment.

BeforeRe-valuation

After re-valuation Investment Final

Al $40 $40 $40.0

Bev 40 40 40.0

Cal $3.3 3.3 $50 53.3

Total $80 $83.3 $133.3

New Partner Investment: Goodwill to New Partner (cont.)



New Partner Investment: Bonus

Al and Bev decide not to revalue the business

assets, and Cal invests $50 cash in the

business for a 1/3 interest.

Cal's new capital = 1/3 of the total $140. Since

he invests $50 cash for a $52 interest, the $2

bonus is transferred from the old partners.

Before Investment Bonus Final

Al $50 ($1) $49

Bev 40 (1) 39

Cal $50 2 52

Total $90 $140



Entries for Investment in Business

Entries for Cal's investment, under goodwill

and bonus methods:Goodwill 20

Al Capital 10

Bev Capital 10

Cash 60

Cal Capital 60

Goodwill method, goodwill to old partners

Cash 50

Al Capital 1

Bev Capital 1

Cal Capital 52

Bonus method, bonus to new partner

5: DEATH OR RETIREMENT

OF A PARTNER







Dissociation

Firm value, according to the Uniform Partnership Act, is the greater of Liquidation value Sales value as a going concern without the

dissociated partnerPayment to exiting partner may be 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



Payment to Exiting Partner

Mo, Nel, and Owen are partners with capital

balances and profit-sharing percentages, shown

respectively, as follows:

Owen retires, and his partnership interest is

paid out by the partnership.



Owen Capital 80

Cash 80

Payment Equals Partner Capital

The Mo, Nel, and Owen partnership would be

dissolved. Mo and Nel could continue the

partnership, but would need to establish a new

partnership agreement if a partner’s retirement

was not addressed in the original partnership

agreement.



Payment Exceeds Partner Capital

If Owen is paid $92,000 in final settlement of

his partnership interest, the excess may be

treated as

1. A bonus to Owen, or

2. Goodwill, in the amount of the excess, or

3. A revaluation of partnership capital based

on the fair value implied by the excess.



Mo Capital 80

Nel Capital 8

Owen Capital 4

Cash 92

Excess Payment:

Bonus to Exiting Partner

By treating the excess payment as a bonus to

Owen, Mo and Nel each have their capital

accounts reduced by their relative profit

sharing ratios of 40:20, for the total amount of

the $12,000 bonus amount.



Owen Capital 80

Goodwill 12

Cash 92

Excess Payment:

Goodwill Recorded

By treating the excess payment as an

indication that partnership assets were

undervalued, Goodwill is recorded. Note

that Mo and Nel’s capital accounts are not

revalued.



Goodwill 30

Mo Capital 12

Nel Capital 6

Owen Capital 12

Excess Payment:

Used to Revalue Partnership Capital

The excess payment is used to determine the

implied fair value of the partnership. $12,000 excess / Owen’s 40% share =

implied partnership under-valuation of $30,000

Owen Capital 92

Cash 92

The exiting partner is then paid the amount of

his capital account.

6: LIMITED PARTNERSHIPS







Limited Partnerships

Limited partnerships must have one or more general partners with unlimited liability for partnership debt.

There may be any number of limited partners. Excluded from participating in management Limited liability for partnership debt Partnership agreement must be in writing,

signed and filed

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Beams ch16 partnership

Education

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