Partnerships: Formation, Operation, and Changes in Membership

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McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Partnerships: Formation, Operation, and Changes in Membership

15Electronic Presentation by

Douglas Cloud Pepperdine University

Baker / Lembke / KingBaker / Lembke / King

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Association of two or more persons. The “persons” are usually individuals; however, they could be corporations or other partnerships.

To carry on as co-owners. A partnership is an aggregation of partners’ individual rights.

Business for profit. A partnership may be formed to perform any legal business, trade, profession, or other service.

Definition of a PartnershipDefinition of a Partnership

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Definition of a PartnershipDefinition of a Partnership

The partnership must attempt to make a profit; therefore, not-for-profit organizations may

not be partnerships.

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The name of the partnership and the names of the partners.

The type of business to be conducted by the partnership and the duration of the partnership agreement.

The initial capital contribution of each partner and the method by which future capital contributions are to be accounted for.

Articles of Copartnership Includes--Articles of Copartnership Includes--

ContinuedContinued

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A complete specification of the profit or loss distribution, including salaries, interest on capital balances, bonuses, limits on withdrawals, and distribution percentage.

Procedures used for changes in the partnership and a retirement of a partner.

Other aspects of operating the partners decide on, such as the management rights of each partners, election procedures, and accounting methods.

Articles of Copartnership Includes--Articles of Copartnership Includes--

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Articles of CopartnershipArticles of Copartnership

Each partner should sign the partnership

agreement to indicate acceptance

of the terms.

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• Limited life. A partnership legally terminates as a business entity each time there is a change in membership.

• Agency relationship. Each partner is a co-owner of the partnership assets and liabilities.

• Unlimited liability. All partners in a general partnership have unlimited liability.

Other Major Characteristics Other Major Characteristics

Also known Also known as as

“Dissolution “Dissolution of the of the

partnership”partnership”Any partner Any partner can bind the can bind the partnership if partnership if acting within acting within the scope of the scope of the partner-the partner-

ship.ship.

Limited Limited partners have partners have

limited limited liability.liability.

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Other Major Characteristics Other Major Characteristics

Limited Liability Partnership

The partners are not personally liability for any debt, obligation, or liability that is chargeable to the partnership. The partners are still liable

up to the amount of their capital accounts.

A limited liability partnership must identify itself by adding the letters LLP

behind the name of the partnership.

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Accounting for Partnership FormationAccounting for Partnership FormationAlt, a sole proprietor, has the following accounts as of December 31, 20X0:

Cash 3,000Inventory 7,000Equipment 20,000

Accumulated Depreciation-- Equipment 5,000Liabilities 10,000Alt, Capital 15,000

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Blue offers to invest $10,000 in the a partnership interest in the business. As part of forming the

partnership, Alt’s business is audited and an appraisal discloses that $1,000 of the liabilities have not been recorded, inventory has a market value of $9,000, and the equipment has a fair

value of $19,000.

Accounting for Partnership FormationAccounting for Partnership Formation

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Accounting for Partnership FormationAccounting for Partnership Formation

January 1, 20X1Cash 13,000Inventory 9,000Equipment 19,000

Liabilities 11,000Alt, Capital 20,000Blue, Capital 10,000

Formation of AB Partnershipby capital contributions of Alt and Blue.

Fair Market Value

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Accounting for Partnership OperationsAccounting for Partnership Operations

Capital Accounts. This account eventually contains the initial investment by each partner, any subsequent capital contributions, profit or loss distributions, and any withdrawals of capital by the partners.

Drawing Accounts. A separate drawing account often is used to record the periodic withdrawals by each partner. Each drawing account is closed to the partner’s capital account at the end of the fiscal period.

ContinuedContinued

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Accounting for Partnership OperationsAccounting for Partnership Operations

Loan Accounts. Any loans between a partner and the partnership should always be accompanied by proper loan documentation such as a promissory note. Unless agreed by all partners, the partnership is obligated to pay interest on the loan to the individual partners.

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Preselected ratio. Interest on capital

balances. Salaries to partners. Bonuses to partners.

Allocating Profit or Loss to PartnersAllocating Profit or Loss to Partners

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Alt Blue Total Profit sharing percentage 60%40% 100% Net income $10,000 Allocate 60:40 $6,000$4,000(10,000)Total $6,000$4,000$ -0-

Illustrations of Profit AllocationIllustrations of Profit Allocation

During 20X1, the AB Partnership earns a profit of $10,000 for the year. Alt maintains a capital balance

of $20,000 during the year, but Blue’s capital investment fluctuates between $6,500 and $10,000.

Profits shared 60%:40%

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Blue, Capital 4,000Blue, Drawing 4,000

Close Blue’s drawing account.

During the year, Blue withdrew $4,000 from the business. A closing entry is needed to reflect this reduction in Blue, Capital.

Income Summary 10,000Alt, Capital 6,000Blue, Capital 4,000

Distribute profit in accordance withpartnership agreement.

Another entry is required to distribute the profit in accordance with the partnership agreement.


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Blue’s Weighted-Average Capital Balance

Average capital: $96,000 12 months = $8,000


Interest on Capital Balances

Months Months Times Date Debit Credit Balance Maintained Dollar Balance

January 1 $10,000 4 $40,000May 1 $3,000 7,000 4 28,000September 1 $500 7,500 2 15,000November 1 1,000 6,500 2 13,000Total 12 $96,000

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Alt and Blue agreed to allow interest of 15 percent on the weighted-average capital balances with any remaining profit to be distributed 60:40 percent.

Alt Blue TotalProfit percentage 60% 40% 100% Average capital $20,000 $8,000Net income $10,000 Interest on average capital $ 3,000 $1,200 (4,200)Residual income $ 5,800 Allocate 60:40 $ 3,480 $2,320 (5,800)Total $ 6,480 $3,520 $ -0-


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The partnership agreement between Alt and Blue provides for salaries of $2,000

for Alt and $5,000 for Blue. Any remainder is to be distributed in the profit

and loss sharing ratio of 60:40 percent.

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Alt Blue TotalProfit percentage 60% 40% 100% Net income $10,000 Salary $2,000 $5,000 (7,000)Residual income $ 3,000 Allocate 60:40 1,800 1,200 (3,000)Total $3,800 $6,200 $ -0-


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BonusesBonuses

A bonus of 10 percent of income in excess of $5,000 is to be credited to Blue’s capital

account before distributing remaining profit.

Bonus = .10 (Net income - Minimum income)Bonus = .10 ($10,000 - $5,000)Bonus = $500

Case 1: The bonus is computed as a percentage of income before subtracting the bonus.

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BonusesBonuses

A bonus of 10 percent of income in excess of $5,000 is to be credited to Blue’s capital

account before distributing remaining profit.

Bonus = .10 (Net income - Minimum income -Bonus)Bonus = .10 ($10,000 - $5,000 - Bonus)Bonus = .10 ($5,000 - Bonus)Bonus = $500 - .10 Bonus

1.10 Bonus = $500Bonus = $454.55

Case 2: The bonus is computed as a percentage of income after subtracting the bonus.

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BonusesBonuses

The distribution of net income based on Case 2 (bonus of $454.55) is calculated as follows:

Alt Blue TotalProfit percentage 60% 40% 100% Net income $10,000Bonus to partner (rounded) $ 455 (455)Residual income $ 9,545Allocation 60:40 $5,727 3,818 (9,545)Total $5,727 $4,273 $ -0-

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Multiple Bases for Profit AllocationMultiple Bases for Profit Allocation

1. Interest of 15 percent on weighted-average capital balances.

2. Salaries of $2,000 for Alt and $5,000 for Blue.

3. A bonus of 10 percent to be paid to Blue on partnership income exceeding $5,000 before subtracting the bonus, partners’ salaries, and interest on capital balances.

4. Any residual to be allocated in the ratio of 60 percent to Alt and 40 percent to Blue.

AB Partnership agreement specifies the following:

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Multiple Bases for Profit AllocationMultiple Bases for Profit Allocation Alt Blue Total

Profit percentage Average capital $20,000 $8,000 Net income $10,000

Step 1:Interest on average capital $ 3,000 $1,200 (4,200)

Remaining after step 1 $ 5,800 Step 2:Salary 2,000 5,000 (7,000)

Deficiency after step 2 $(1,200)Step 3:Bonus 500 (500)

Deficiency after step 3 $(1,700)Step 4:Allocate 60:40 (1,020) (680) 1,700

Total $3,980 $6,020 $ -0-

60% 40% 100%

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Partnership Financial StatementPartnership Financial Statement

AB PartnershipStatement of Partners’ Capital

For the Year Ended December 31, 20X1 Alt Blue Total

Balance, January 1, 20X1 $20,000 $10,000 $30,000Add: Additional investment 500 500

Net income distribution 3,980 6,020 10,000$23,980 $16,520 $40,500

Less: Withdrawal (4,000) (4,000)Balance, December 31, 20X1 $23,980 $12,520 36,500

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Changes in MembershipChanges in Membership

Admission of a new partner

Withdrawal of a partner

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New Partner Purchases an InterestNew Partner Purchases an Interest

On January 1, 20X3, Alt and Blue invite Cha to become a partner in their business. Cha purchases a one-fourth interest

in the partnership capital directly from Alt and Blue by paying $5,900 to Alt and $3,100 to Blue. Cha will have a capital credit of $7,500 (.25 x total capital, $30,000). Cha will be entitled to 25 percent interest in the profits or losses of the

partnership. The remaining 75 percent interest will be divided between Alt and Blue in their old profit ratio of 60:40.

Alt, Capital ($20,000 x .25) 5,000Blue, Capital ($10,000 x .25) 2,500

Cha, Capital 7,500Reclassifying capital to new partner.

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New Partner Invests in PartnershipNew Partner Invests in Partnership

New partner’s

proportion of the

partnership’s book value

Prior capital of present partners

Investment of new partner

Percentage of capital

to new partner

+= x

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Case 1: The total book value of the partnership before the admission of Cha is $30,000. Cha buys one-fourth interest for $10,000.

Cash 10,000Cha, Capital ($40,000 x .25) 10,000

Admission of Cha for one-fourth interestupon investment of $10,000.

Investment in partnership $10,000 New partner’s proportionate book value ($30,000 + $10,000) x .25 (10,000)Difference $ -0-

New Partner Invests Amount Equal to Book ValueNew Partner Invests Amount Equal to Book Value

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Case 2: The total book value of the partnership before the admission of Cha is $30,000. Cha buys one-fourth interest for $11,000.

New Partner Invests More Than Book ValueNew Partner Invests More Than Book Value

Investment in partnership $11,000 New partner’s proportionate book value ($30,000 + $11,000) x .25 (10,250)Difference $ 750

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Three alternative accounting treatments exist in this case:

ContinuedContinued

1. Revalue assets upward. Under this alternative:a. Asset book values are increased to their market

values.b. The prior partners’ capital accounts are

increased for their respective shares of the increase in the book values of the assets.

c. Total resulting capital of the partnership is the prior capital balances plus the amount of asset revaluation plus the new partner’s investment.

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ContinuedContinued

2. Record unrecognized goodwill. With this method:a. Unrecognized goodwill is recorded.b. The prior partners’ capital accounts are

increased for their respective shares of the goodwill.

c. Total resulting capital of the partnership is the prior capital balances plus the goodwill recognized plus the new partner’s investment.

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3. Use bonus method . Essentially, the bonus method is a transfer of capital balances among the partners. This method is used when the partners do not wish to record adjustments in asset accounts and do not want to recognize goodwill. Under this method:a. The prior partners’ capital accounts are

increased for their respective shares of the bonus paid by the new partner.

b. Total resulting capital of the partnership is the prior capital balances plus the new partner’s investment.

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Case 2: Revaluation of assets. Cha was willing to pay more than one-fourth the book value because the partnership’s land was undervalued by $3,000. This increase in value is allocated to the two original partners in a 60:40 ratio.

Land 3,000Alt, Capital (60%) 1,800Blue, Capital (40%) 1,200

Revalue partnership land to market value.



Admission of Cha for one-fourth capitalin ABC Partnership.

Total resulting capital is $44,000.

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Step 1:25% of estimated total resulting capital $11,000Estimated total resulting capital ($11,000 .25) $44,000

Step 2:Estimated total resulting capital $44,000Total net assets not including goodwill ($30,000 + $11,000) (41,000)Estimated goodwill to prior partners $ 3,000

Case 2 (continued): Goodwill recognition. If Cha invests $11,000 for one-fourth interest, she must feel that the resulting partnership’s capital is $44,000.


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First, the unrecorded goodwill is recorded and the two original partners’ capital accounts are adjusted.

Goodwill 3,000Alt, Capital (60%) 1,800Blue, Capital (40%) 1,200

Recognize unrecorded goodwill.


Admission of Cha to partnership for one-fourth capital interest.

Next, Cha’s investment is recorded.


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Case 2 (continued): The bonus method. The bonus method avoids reevaluating assets and recognizing goodwill. First, the new total capital is determined:

$30,000 + $11,000 = $41,000Cha’s proportion of the resulting capital is 25 percent or $10,250 ($41,000 ÷ 4). The remaining $750 is divided between the original partners 60:40.

Cash 11,000Alt, Capital ($750 x .60) 450Blue, Capital ($750 x .40) 300Cha, Capital 10,250

Admission of Cha with bonus to Alt andBlue.


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New Partner Invests Less Than Book ValueNew Partner Invests Less Than Book Value

Case 3: Cha invests $8,000 for a one-fourth capital interest in the ABC Partnership.

Investment in partnership $ 8,000 New partner’s proportionate book value ($30,000 + $11,000) x .25 (9,500)Difference (investment< book value) $(1,500)

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Three alternative accounting approaches are:

ContinuedContinued

1. Revalue assets downward. Under this alternative:a. Asset book values are decreased to recognize

the reduction in their values.b. The prior partners’ capital accounts are

decreased for their respective shares of the decrease in the book values of the assets.

c. Total resulting capital of the partnership is the prior capital balances less the amount of asset valuation write-down plus the new partner’s investment.

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ContinuedContinued

2. Recognize goodwill brought in by the new partner. In this approach:a. Goodwill or other intangible benefits brought in by the

new partner are recorded and also included in the new partners’ capital account.

b. The prior partners’ capital accounts remain unchanged.c. Total resulting capital of the partnership is the prior

capital balances plus the new goodwill brought in plus the new partner’s tangible investment.

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3. Use bonus method . Under the bonus method:a. The new partner is assigned a bonus from the prior

partners’ capital accounts, which are decreased for their respective shares of the bonus paid to the new partner.

b. Total resulting capital of the partnership is the prior capital balances plus the new partner’s investment.

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Case 3: Revaluation of Assets. Alt and Blue agree to accept Cha to a one-fourth interest for an $8,000 investment. The original partners agree to write down the inventory to its fair value before admission of Cha.

Alt, Capital ($6,000 x .60) 3,600Blue, Capital ($6,000 x .40) 2,400

Inventory 6,000Revalue inventory to market. .


Cha’s investment of $8,000 is recorded.

Cash 8,000Cha, Capital 8,000

Admission of Cha to partnership. .

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Case 3 (continued): Recognize goodwill. Alt and Blue agree to accept Cha to a one-fourth interest for an $8,000 investment. Alt, Blue, and Cha agree that Cha’s abilities will generate excess earnings for the resulting ABC Partnership.


Step 1:75% of estimated total resulting capital $30,000 Estimated total resulting capital($30,000 .75) $40,000

Step 2:Estimated total resulting capital $40,000 Total net assets not including goodwill($30,000 + $8,000) (38,000)Estimated goodwill $ 2,000

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The entry to record the admission of Cha into the ABC Partnership is:


Cash 8,000Goodwill 2,000

Cha, Capital 10,000Admission of Cha to partnership.

The total resulting capital of the ABC Partnership is now $40,000, with Alt and Blue together having a 75 percent

interest and Cha having a 25 percent interest.

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Case 3 (continued): Bonus to new partner. Alt and Blue agree to accept Cha to a one-fourth interest for an $8,000 investment. The original partners’ capital accounts are reduced by $1,500 in their profit and loss ratio.

Cash 8,000Alt, Capital ($1,500 x .60) 900Blue, Capital ($1,500 x .40) 600

Cha, Capital 9,500

Admission of Cha to partnership.


The capital credit assigned to the new partners is her share of the total resulting capital ($30,000 + $8,000) x .25.

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Bonus to retiring partner. Asset revaluation and then payment to retiring

partner. Goodwill to retiring partner:

Only recognize retiring partner’s share of goodwill. Recognize all goodwill.

Retirement of a Partner from PartnershipRetirement of a Partner from Partnership

May account for using:

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Chapter FifteenChapter Fifteen

The The EndEnd

Partnerships: Formation, Operation, and Changes in Membership

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