FISCHER | TAYLOR | CHENG Partnerships: Ownership Changes and Liquidations

Learning Objectives (1 of 2) 1.Understand that changes in the ownership of a partnership do not necessarily result in the dissolution and winding up of a partnership. 2.Account for the partners’ capital balances under the bonus method. 3.Account for the partners’ capital balances under the goodwill method. 4.Describe the conceptual differences between the bonus and goodwill methods. 5.Account for the admission of a new partner through direct contribution to an existing partner. COPYRIGHT © 2012 South-Western/Cengage Learning 2

Learning Objectives (2 of 2) 6.Explain the impact of a partner’s withdrawal from the partnership. 7.Describe the order in which assets must be distributed upon liquidation of a partnership, and explain the right- of-offset concept. 8.Understand the treatment for capital deficiencies and unsatisfied creditors. 9.Calculate the assets to be distributed to a given partner in a lump-sum or installment liquidation, and understand the concept of maximum loss absorbable. 10.Prepare an installment liquidation statement and a schedule of safe payments. COPYRIGHT © 2012 South-Western/Cengage Learning 3

Ownership Changes A transfer of a partner's interest does not necessary result in –The dissociation of the transferring partner –The dissolution and winding up of the partnership Entity theory –Partnership entity should continue if a partner is dissociated Propriety theory –Views a partnership as a group of individual investors COPYRIGHT © 2012 South-Western/Cengage Learning 4

Ownership Changes Presumed to be arms’-length transactions Changes may indicate: –Previously unrecorded intangible assets exist that are traceable to the original partnership –Intangible assets, such as goodwill, exist that are traceable to a new partner A change in ownership normally suggests the need to both revalue net assets and recognize intangible assets COPYRIGHT © 2012 South-Western/Cengage Learning 5

Admission of a New Partner Accomplished by either: –A contribution of assets to an existing partnership Either the bonus or goodwill method of accounting is employed –A contribution of assets to an existing partner Generally a transfer of book values from one partner to another COPYRIGHT © 2012 South-Western/Cengage Learning 6

The Value of Assets Contributed to an Existing Partnership May be in excess of that suggested by the book value of the original partnership’s net assets which suggests that the partnership may have one of the following: Unrecognized appreciation on recorded net assets Unrecognized goodwill COPYRIGHT © 2012 South-Western/Cengage Learning 7 Admission of a new partner

The Value of Assets Contributed to an Existing Partnership Unrecognized depreciation or write-downs on recorded net assets of the original partnership Additional intangible assets being contributed by the incoming partner COPYRIGHT © 2012 South-Western/Cengage Learning 8 May be less than that suggested by the book value of the original partnership’s net assets which suggests that the partnership may have one of the following: Admission of a new partner

Contribution of Assets to an Existing Partnership Incoming partner’s contribution is different from that indicated by the book values of the original partnership Indicated treatment –Adjust existing assets and/or –Recognize goodwill Mutually exclusive methods –Bonus method –Goodwill method COPYRIGHT © 2012 South-Western/Cengage Learning 9 Admission of a new partner

The Bonus Method Total capital of new partnership is: The book value of the previous partnership minusAny write-downs in the value of the previous partnership’s net assets plusThe value of the consideration paid to the partnership by the incoming partner COPYRIGHT © 2012 South-Western/Cengage Learning 10 Note:Only net asset write-downs (versus write-ups) are recognized. Admission of a new partner

The Bonus Method New partner’s initial capital balance equals the percent interest in the capital of the new partnership Bonus may be either to old partners or the new partner Bonus is allocated based on profit/loss percentages, not interest in capital percentages COPYRIGHT © 2012 South-Western/Cengage Learning 11 Admission of a new partner

Bonus Method: Bonus to the Original Partners COPYRIGHT © 2012 South-Western/Cengage Learning 12 Assets27,000 A, Capital3,300 B, Capital3,300 C, Capital20,400 Admission of a new partner

Bonus Method: Bonus to the New Partner COPYRIGHT © 2012 South-Western/Cengage Learning 13 Assets10,000 A, Capital3,500 B, Capital3,500 C, Capital17,000 Admission of a new partner

Overvaluation of the Original Partnership COPYRIGHT © 2012 South-Western/Cengage Learning 14 A, Capital17,500 B, Capital17,500 Assets35,000 Assets10,000 C, Capital10,000 Admission of a new partner

The Goodwill Method COPYRIGHT © 2012 South-Western/Cengage Learning 15 Total capital of new partnership is: The book value of the previous partnership plusUnrecognized appreciation and/or minusUnrecognized depreciation on the recorded net assets of the previous partnership plusUnrecognized goodwill traceable to the previous partnership plusThe value of the consideration, both tangible and intangible, received from the new incoming partner Admission of a new partner

Bonus Method vis-à-vis Goodwill Method Bonus method the total capital of the new entity equals the book value of the previous partners’ capital adjusted for asset write-downs, if appropriate, plus the incoming partner’s investment Goodwill method the total capital of the new partnership must approximate the fair value of the entity COPYRIGHT © 2012 South-Western/Cengage Learning 16 Admission of a new partner

Asset Appreciation COPYRIGHT © 2012 South-Western/Cengage Learning 17 Land43,000 Inventory10,000 A, Capital16,500 B, Capital16,500 Assets27,000 C, Capital27,000 Admission of a new partner

Goodwill Attributable to Original Partners COPYRIGHT © 2012 South-Western/Cengage Learning 18 Goodwill33,000 A, Capital16,500 B, Capital16,500 Assets27,000 C, Capital27,000 Admission of a new partner

Asset Write-down COPYRIGHT © 2012 South-Western/Cengage Learning 19 Land20,000 A, Capital17,500 B, Capital17,500 Inventory55,000 Assets10,000 C, Capital10,000 Admission of a new partner

Goodwill Traceable to the New Partner COPYRIGHT © 2012 South-Western/Cengage Learning 20 Assets10,000 Goodwill8,750 C, Capital18,750 Admission of a new partner

Revaluation of Assets and Goodwill COPYRIGHT © 2012 South-Western/Cengage Learning 21 A, Capital5,500 B, Capital5,500 Assets11,000 Assets10,000 Goodwill6,000 C, Capital16,000 Admission of a new partner

Methodology for Determining Goodwill 1.Determine the entity’s fair value, as indicated by the new partner’s investment (new partner’s investment divided by the percentage interest acquired in the partnership). …continued… COPYRIGHT © 2012 South-Western/Cengage Learning 22 Admission of a new partner

Methodology for Determining Goodwill 2.If the fair value determined is: a.Greater than the book value of the new partnership adjusted for net appreciation or net write-downs, implied goodwill is traceable to the original partners and is allocated among them according to their original profit ratios. b.Less than the adjusted book value of the new partnership, implied goodwill is traceable to the new partner. …continued… COPYRIGHT © 2012 South-Western/Cengage Learning 23 Admission of a new partner

Methodology for Determining Goodwill 3.The initial capital balance of the new partner always is equal to the new partner’s interest in the total capital of the new partnership after goodwill is recognized. COPYRIGHT © 2012 South-Western/Cengage Learning 24 Admission of a new partner

Contribution of Assets to Existing Partners The new partner deals directly with an existing partner (s) rather than with the partnership entity Partnership records transfer of capital No assets are received by partnership COPYRIGHT © 2012 South-Western/Cengage Learning 25 A, Capital15,000 B, Capital22,500 C, Capital37,000 Admission of a new partner

Withdrawal of a Partner Sell equity interest to an individual –Partnership entity records transfer of equity Sell equity interest to the partnership –Bonus method Difference between exiting partner equity and fair value Remaining partners grant bonus to exiting partner Bonus charged according to proportionate P&L ratio –Goodwill method Payment to exiting partner indicates fair value of partnership Recognize goodwill only to exiting partner or the entire entity COPYRIGHT © 2012 South-Western/Cengage Learning 26

Selling of an Interest to an Individual COPYRIGHT © 2012 South-Western/Cengage Learning 27 Withdrawal of a partner A, Capital30,000 C, Capital3,000 A sells equity to C for $36,000

Selling of an Interest to the Partnership COPYRIGHT © 2012 South-Western/Cengage Learning 28 Withdrawal of a partner A, Capital30,000 B, Capital (4/6)4,000 C, Capital (2/6)2,000 Cash36,000 A sells equity to the partnership for $36,000 Bonus method

Selling of an Interest to the Partnership COPYRIGHT © 2012 South-Western/Cengage Learning 29 Withdrawal of a partner Goodwill6,000 A, Capital6,000 A, Capital36,000 Cash36,000 A sells equity to the partnership for $36,000 Goodwill to exiting partner

Selling of an Interest to the Partnership COPYRIGHT © 2012 South-Western/Cengage Learning 30 Withdrawal of a partner Goodwill ($6,000 ÷ 40%)15,000 A, Capital6,000 B, Capital6,000 C, Capital3,000 A, Capital36,000 Cash36,000 A sells equity to the partnership for $36,000 Goodwill traceable to entire entity

Partnership Liquidation Guidelines RUPA priority (subject to an agreement to the contrary) 1.Use assets to discharge obligations to creditors including partners who are creditors on parity with other creditors 2.Profits (losses) from liquidation allocated to partners 3.Partner with deficit capital balance Makes contribution equal to the deficit balance Solvent partners proportionally absorb any remaining deficiency 4.Final cash distribution to partners based on capital balances COPYRIGHT © 2012 South-Western/Cengage Learning 31

Partnership Liquidation Guidelines Doctrine of right of offset –Not addressed in RUPA –Incorporated into partnership agreement –Amounts due to partners as creditors are combined with the respective partners’ capital balances. –Avoids possibility of distributing assets to a creditor/partner where that partner has a debit (deficit) capital balance COPYRIGHT © 2012 South-Western/Cengage Learning 32

Liability for Debit Capital Balances Partners contribute assets to clear deficit balance Remaining debit balance proportionally allocated to solvent partner(s) Amounts owned to partners are on equal basis with personal creditors COPYRIGHT © 2012 South-Western/Cengage Learning 33 Partnership liquidation

Unsatisfied Partnership Creditors Unsatisfied partnership creditors look to personal assets of the partners. RUPA: unsatisfied partnership creditors share pro rata with the partners' personal or individual creditors in the assets of the partners' estate. COPYRIGHT © 2012 South-Western/Cengage Learning 34 Partnership liquidation

Types of Liquidation Approaches Lump sum liquidation –All assets are in a distributable form and all outside creditors are satisfied before distributions are made to partners Installment liquidation –Payments may be made to partners only after anticipating all liabilities, possible losses, and liquidation expenses COPYRIGHT © 2012 South-Western/Cengage Learning 35 Partnership liquidation

Lump-sum Liquidation COPYRIGHT © 2012 South-Western/Cengage Learning 36 Partnership liquidation Gains and losses on realization are allocated per partners’ profit and loss ratio. Claims against the partnership are paid in the proper order subject to the concept of the right of offset

Lump-sum Liquidation COPYRIGHT © 2012 South-Western/Cengage Learning 37 Partnership liquidation Gains and losses on realization are allocated per partners’ profit and loss ratio. Claims against the partnership are paid in the proper order subject to the concept of the right of offset Partners with deficit capital balances contribute personal assets as able to eliminate the deficit.

Lump-sum Liquidation COPYRIGHT © 2012 South-Western/Cengage Learning 38 Partnership liquidation Gains and losses on realization are allocated per partners’ profit and loss ratio. Claims against the partnership are paid in the proper order subject to the concept of the right of offset Partners with deficit capital balances contribute personal assets as able to eliminate the deficit. C’s debit capital balance is charged against A, the only partner with a credit capital balance.

Types of Liquidation Approaches Installment liquidation –Payments may be made to partners in installments rather than in a final lump sum –Caution must be exercised to insure that no premature distributions are made –A schedule of safe payments, showing appropriate distributions to partners, is prepared as amounts become available for distribution COPYRIGHT © 2012 South-Western/Cengage Learning 39 Partnership liquidation

Installment Liquidation: Phase1 COPYRIGHT © 2012 South-Western/Cengage Learning 40 Note: Gains and losses on realization are allocated according to the partners’ profit and loss ratio. Unsold noncash assets are assumed to be worthless for purposes of determining the safe payments to partners.

Installment Liquidation: Phase 2 COPYRIGHT © 2012 South-Western/Cengage Learning 41 Note: Distributions are applied to a partner’s loan balance before they are applied to the partner’s capital balance. All partners received a distribution in this iteration; future cash installments are made per P&L ratio

Installment Liquidation: Phase 3 COPYRIGHT © 2012 South-Western/Cengage Learning 42 Note: Cash distributions were made per P&L ratio Partner A’s $8,000 Mar 18 distribution ($20,000 × 40%) was first applied to the loan balance