Advanced Accounting by Debra Jeter and Paul Chaney Chapter 16: Partnerships: Formation, Operation, and Ownership Changes Slides Authored by Hannah Wong, Ph.D. Rutgers University

Partnership lDefinition n An association of two or more persons to carry on as co-owners of a business for profit lAttributes n an agreement n the business operates for profit n members of the firm must be co-owners

General Partnership lAll partners are general partners lMutual agency lRight to dispose of a partnership interest lUnlimited liability lLimited or uncertain life lTax implications: partnership income is allocated to partners who are taxed upon

Limited Partnership lAt least one general partner and one limited partner lGeneral partner: n manage the firm n unlimited liability lLimited partner: n invest capital only n limited liability

Joint Venture lAn agreement by two or more parties to accomplish a limited purpose for their mutual benefit, often to earn a profit. lEach joint venturer participates directly or indirectly in the management of the resources

Partnership Agreement n name of the firm, identity of the partners n nature, purpose and scope of business n date of organization n length of operating time n location of business n allocation of profit and loss n salaries and withdrawals of assets by partners n rights, duties and obligations of each partner n contractual authority of each partner

Partnership Agreement n procedure for admitting a new partner n plan on withdrawal or death of a partner n procedures for arbitration of disputes n fiscal period n identification and valuation of initial asset investments n situations for dissolution of partnership n accounting practices n whether an audit is to be performed

Capital Interest VS Profit Interest Capital interest n a partner’s claim against the net assets of the partnership n shown by the balance in the partner’s capital account Profit interest n a partner’s claim against income and loss of the partnership n determines how the partner’s capital interest changes as a result of partnership operations

Accounting for a Partnership Cash50,000 Bell, capital50,000 Peters, capital50,000 Formation of Partnership Bell, drawing1,000 Peters, drawing1,000 Cash1,000 Monthly Withdrawal

Accounting for a Partnership Income summary60,000 Bell, capital30,000 Peters, capital30,000 Income Summary Closing Entry Bell, capital12,000 Peters, capital12,000 Bell, drawing12,000 Peters, drawing12,000 Drawing Accounts Closing Entry

Bonus Method MV of asset investment = negotiated capital interest Assets contributed by Wright $40,000 Assets contributed by Young $50,000 Fair value of assets invested $90,000 Wright, capital $45,000 Young, capital $45,000

Goodwill Method MV of asset investment = negotiated capital interest Assets contributed by Wright $40,000 Assets contributed by Young $50,000 $90,000 Fair value of assets invested Wright, capital $50,000 Young, capital $50,000 Goodwill of $10,000 is recorded

Profit/Loss Allocation Profit $20,000 Fixed Ratio Adams $14,000 Brown $6,000 7:3

Profit/Loss Allocation Profit $20,000 Capital Balances Adams $14,000 Brown $6,000 7:3 Adams Capital $60,000Brown Capital $40,000 3:2 = 3:2

Profit/Loss Allocation Steps: (1) Allocate profit as interest on capital investment (2) allocate the remaining income on another basis Interest Allocation

Profit/Loss Allocation lThe following should be specified: n the interest rate n capital balance to be used n how remaining profit should be allocated n whether or not interest should be allocated if profit < agreed interest allocation Interest Allocation

Profit/Loss Allocation Profit $20,000 Interest Allocation Adams $5,400 Brown $5,400 1:1 Interest allocated = capital balance x interest rate 7:3 Adams $6,200 Brown $3,000 Unallocated profit Interest allocation Allocation of remaining profit

Profit/Loss Allocation lAllocate profit as: n fixed salary or n provide for a bonus as a % of net income lThe net income used in bonus calculation can be n before allocation of income to partners n after other allocations, but before the bonus n after bonus, but before other allocations n after bonus and all other allocations Salary and Bonus Allocation

Insufficient Income to Cover Allocation lIf partnership income > interest and/or salary allocation lallocate the deficiency in the agreed ratio for allocating residual income

Insufficient Income to Cover Allocation Profit $11,000 Adams ($2,100) Brown ($2,100) 1:1 7:3 Adams $4,000 Brown $3,000 Deficiency in profit Salary allocation Adams $6,200 Brown $2,000 Interest allocation

Financial Statement Presentation lDifference between partnership and corporation reporting: n changes in partners’ equity during the year should be disclosed n partners’ salary allowances is not an expense n no income tax expense n interest on capital investment is not an expense.

Admission of New Partner A new partner can acquire an interest in a partnership by: lpurchasing an interest from an existing partner n New partner acquires the right to share profits only n no right to participate in management unless granted by all remaining partners linvesting assets

Assignment of Partnership Interest By Payment to Partners - Bonus Method Adams, Capital 18,000 Brown, Capital12,000 Call, Capital30,000 To transfer capital from capital accounts of Adams and Brown to Call’s capital account. Amounts = recorded capital x % interest acquired by Call

Assignment of Partnership Interest By Payment to Partners - Goodwill Method Adams, Capital 18,000 Brown, Capital12,000 Call, Capital30,000 To transfer capital from capital accounts of Adams and Brown to Call’s capital account. Goodwill20,000 Adams, Capital 12,000 Brown, Capital 8,000 To record implied goodwill = Call’s payments / % interest acquired - recorded partnership net assets = $36000 / 30% -$100,000

Asset Investment BV Acquired = Assets Invested Cash35,000 Call, Capital35,000 To record Call’s 1/3 capital in the partnership = (existing net assets + assets invested by Call) x 1/3 = ($70,000 + $35,000) x 1/3 = $35,000

Asset Investment BV Acquired < Assets Invested : Bonus Method Cash50,000 Call, Adams 6,000 Call, Brown 4,000 Call, Capital40,000 To record Call’s 1/3 capital in the partnership = (existing net assets + assets invested by Call) x 1/3 = ($70,000 + $50,000) x 1/3 The excess is considered a bonus to the existing partners

Asset Investment BV Acquired < Assets Invested : Goodwill Method Goodwill30,000 Adams, Capital 18,000 Brown, Capital 12,000 Implied total net assets = Call’s payments / % interest acquired = $50000 / 30% = $150,000 goodwill for existing partners = implied net assets x % ownership - current capital accounts = $150,000 x 2/3 - $70,000 = $30,000

Asset Investment BV Acquired < Assets Invested : Goodwill Method Cash50,000 Call, Capital 50,000 To record Call’s 1/3 capital in the partnership = (implied net assets) x 1/3 = $150,000x 1/3

Payment to a Retiring Partner Payment > BV: Bonus Method Call, Adams 30,000 Call, Brown 6,000 Call, Capital 4,000 Liability to Adams40,000 To record $40,000 agreed payment to Adams The excess is considered a bonus to the retiring partners; allocated to existing partners by their profit and loss ratio

Payment to a Retiring Partner Payment > BV: Goodwill Method Goodwill20,000 Adams, Capital 10,000 Brown, Capital 6,000 Call, Capital 4,000 Implied goodwill = excess payment to Adams / % interest withdrawn = $10000 / 50% = $200,000 The goodwill is allocated to partners by their profit and loss ratio

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