Chapter 15: Partnerships Formation, Operations, and Changes in Ownership Interests

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy to accompany Advanced Accounting, 10th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn

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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.

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Objectives (cont.)
5. Value a partner's share upon retirement or death. 6. Understand limited liability partnership characteristics.

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Partnerships Formation, Operations, and Changes in Ownership Interests

1: Characteristics of Partnerships

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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
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Articles of Partnership
1. Products or services, line of business 2. Partner rights & 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

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Partnership Reporting
Financial reporting should provide for the needs of Partners Creditors of the partnership IRS

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Partnerships Formation, Operations, and Changes in Ownership Interests

2: Initial Investment

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Initial Investment
Cash Amy Capital Cash Paul Capital XXX XXX XXX XXX

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 Equipment Land Paul Capital
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XXX XXX XXX XXX

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Initial Investment with Bonus or Goodwill

Partner 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
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Initial Investment with Bonus

Total fair value received is split, as desired, between partners Cola 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 each
Cash Inventory Land Building Cola Capital Crown Capital
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7 35 10 40 46 46
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Initial Investment with Goodwill

If Cola and Crown agree to equal shares, use larger implied total value of firm. Cola's: (10 + 40) / 50% = $100 Crown's: (7 + 35) / 50% = $84 Implied value of firm $100
Cola's 50%(100) He invests: Land $10 Building $40 $50 Crown's 50%(100) He invests: Cash $7 Inventory $35 Goodwill $50

$50

$42 $8
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Initial Entry with Goodwill

Land 10 Building 40 Cola Capital To record Cola's investment Cash 7 Inventory 35 Goodwill 8 Crown Capital To record Crown's investment and goodwill 50

50

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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.

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Sample Partner Closing Entries

Drawings / withdrawals are closed to individual capital accounts.

Amy Capital Amy Drawings Amy Withdrawals

XXX XX XX XXX XXX XXX

Reduces Amy's capital for drawings and withdrawals

Paul Capital XXX Paul Drawings Income Summary Profit Amy Capital Paul Capital To share profits between Amy and Paul

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.
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Statement of Partners' Capital

Beginning capital + investments drawings and/or withdrawals + income or loss = ending capital
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Partnerships Formation, Operations, and Changes in Ownership Interests

3: Sharing Profit and Loss

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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
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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

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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

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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.

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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.

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Share Profits of $660

Net income Salary allowance Bonus allowance Interest allowance Subtotal Split 60:40 Allocated net income Bonus = 50%(660 - 500) = 80 Tom Interest = 10%(400) = 40 Betty Interest = 10%(350) = 35 60%(415) = 249; 40%(415) = 166
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Total Tom Betty $660 (90) $60 $30 (80) 0 80 40 35 (75) $415 166 (415) 249 $0 $349 $311

Share Profits of $180

Assume instead that income was only $180. Total Tom Betty Net income $120 Salary allowance (90) $60 $30 Bonus allowance 0 0 0 40 35 Interest allowance (75) Subtotal, deficit ($45) Split 60:40 45 (27) (18) Allocated net income $0 $73 $47 Bonus = zero, income does not exceed threshold Tom Interest = 10%(400) = 40 Betty Interest = 10%(350) = 35 60%(-45) = -27; 40%(-45) = -18
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Partnerships Formation, Operations, and Changes in Ownership Interests

4: Admitting a New Partner

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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
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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 Assignee Capital XXX XXX

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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.
Alfano Capital Cobb Capital Before Capital Share $50 50% 50 50% $100 25 25 After Capital Share $25 25% 50 50% 25 25% $100
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Alfano Bailey Cobb Total

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

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

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Goodwill Revalues Capital

Don Ed Fay Total After Before Revaluation revaluation $50 $15 $65 40 15 55 $90 $120 Transfer ($35) (25) 60 Final $30 30 60 $120

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.
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Buy from Partner: Bonus

If Don and Ed had decided not to revalue the assets or record goodwill, the bonus method is used. Before Transfer Final
Don Ed Fay Total $50 40 $90 ($27.5) $22.5 (17.5) 22.5 45.0 45.0 $90.0

Fay's capital is 50%(90) = $45. Don and Ed Capital accounts are adjusted to their new balances 25%(90) = $22.5
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Entries for Purchase from Partner

Entries for Fay's admission, under goodwill and bonus methods:
Goodwill 30 Don Capital Ed Capital Don Capital 35 Ed Capital 25 Fay Capital Goodwill method, aligning capital accounts Don Capital 27.5 Ed Capital 17.5 Fay Capital Bonus method, aligning capital accounts 15 15 60

45
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Invest in Business: Goodwill

Andrew 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 $80 130 Additional investment 50 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.
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Investment and Goodwill Add to Capital (Goodwill to Old Partners)

Revalu- After reBefore ation valuation Investment Final Andrew $40 $10 $50 $50 10 50 50 Boyles 40 Criner $50 50 Total $80 $100 $150

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

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Invest in Business: Goodwill

Andrew 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) $133.3 Old capital, $40 + 40 $80 130.0 Additional investment 50 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.
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Investment and Goodwill Add to Capital (Goodwill to New Partner)

Revalu- After reBefore ation valuation Investment Final Andrew $40 $40 $40.0 40 40.0 Boyles 40 Criner $3.3 3.3 $50 53.3 Total $80 $83.3 $133.3

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

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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.
Andrew Boyles Criner Total Before Investment $50 40 $50 $90 Bonus ($1) (1) 2 Final $49 39 52 $130

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.
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Entries for Investment in Business

Entries for Criner's investment, under goodwill and bonus methods:
Goodwill Andrew Capital Boyles Capital Cash Criner Capital Goodwill method, goodwill to old partners Cash Andrew Capital Boyles Capital Criner Capital Bonus method, bonus to new partner 20 10 10 60 60 50 1 1 52
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Partnerships Formation, Operations, and Changes in Ownership Interests

5: Death or Retirement of a Partner

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Dissociation
Firm value, according to RUPA, is the greater of Liquidation value Sales value as a going concern without the dissociated partner Payment 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
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Partnerships Formation, Operations, and Changes in Ownership Interests

6: Limited Liability Partnership

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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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