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.

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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

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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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

The bonus method splits the capital evenly between the two partners. The new partner receives a capital bonus in recognition of artistic or other abilities contributed.

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Bonus Method

Goodwill Method

Based on assumption that an implied value can be calculated mathematically and recorded for an intangible contribution made by a partner.

Learning Objective 14-5

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

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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Learning Objective 14-6

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

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 Techniques

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

The number of 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.

Learning Objective 14-7

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

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

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

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 PartnerPurchase of a Current Interest

Assume Scott, Thompson, and York formed a partnership, and York leaves the partnership. He sells his interest to Morgan.

Book Value Approach 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

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Goodwill Approach

Scott, Thompson, and York transfer 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 a complete revaluation of all assets and liabilities.

Learning Objective 14-9

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

Admission of a New Partner - Contribution to the Partnership

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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.

Admission of a New Partner - Contribution to the Partnership

Bonus Credited to Original Partners

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Goodwill Credited to Original Partners

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

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Prepare journal entries torecord the withdrawal of acurrent partner.

Withdrawal of a Partner

Goodwill Method Applied

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Bonus Method Applied

Withdrawal of a Partner

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Hybrid Method Applied