Partnerships: Formation, Operation, and Changes in Membership Chapter 15 Partnerships: Formation, Operation, and Changes in Membership Note: We provide a summary of the slides and suggestions on how they might be used in the instructor’s manual for each chapter.   We have attempted to provide PowerPoint slides that will be useful to a broad set of users.  Since instructors often have different styles and preferences, we have attempted to include slides that will accommodate different approaches and that can be adapted to classes with different levels of preparation.  For example, some instructors prefer to introduce the material before students have read the chapter.  We have tried to facilitate these types of introductory discussions by including slides that replicate key points from the chapter. Other instructors expect students to have read the chapter and attempted homework problems before coming to class.  As a result, they may not find it useful to review all of the topics in the chapter or to include slides that simply review many of the details they expect students to study before class.  However, instructors following this approach often like to use sample exercises and problems built into the slides that allow them to have extended discussions or to facilitate group interaction in class. If instructors elect to spend two class periods on the same subject, they might find a combination of both styles to be useful by first introducing foundational material before students have read the chapter and studied the topic, followed by an extended discussion the next class period after students have read the chapter and attempted homework problems. We have tried to develop slides that can facilitate a flexible approach to allow instructors to select the slides that best match their objectives and style for class discussions.  This is the reason we are including a large number of slides for some chapters in the text.  We do not expect all instructors to use all slides, but the slide files should help support different teaching approaches and allow instructors to select the subset of slides that best matches their specific discussion objectives.  The slides are organized by learning objective. We have included a slide at the beginning of each learning objective to show where the new material begins. Instructors may or may not want to use these learning objective slides in class. We provide them primarily as a way of organizing the material. We also include short multiple choice questions at the end of most learning objectives. Some instructors find it useful to pause periodically during class to assess students’ level of understanding. For this reason, we include several “practice quiz questions” that can be used throughout class discussions to engage students, help them focus on key points, or to facilitate group interaction. Finally, we provide longer exercises and problems that many instructors find useful in assessing understanding and encouraging group learning.

Understand and explain the nature and regulation of partnerships. Learning Objective 15-1 Understand and explain the nature and regulation of partnerships.

The Nature of the Partnership Entity The partnership is a popular form of business today because it is easy to form and allows individuals to combine their talents and skills in a particular business venture. Accounting for partnerships requires recognition of several important factors: Partnership is a separate business entity. Although many partnerships account for their operations using accrual accounting, others use the cash basis or modified cash basis of accounting. 3

Legal Regulation of Partnerships Each state regulates the partnerships that are formed in it. Most states begin with a model act and then modifies it to fit that state’s business culture and history. Most have now adopted the Uniform Partnership Act of 1997 (UPA 1997) as their model act. 4

Legal Regulation of Partnerships The UPA 1997 covers: Relations of partners to one another. Relations of partners to persons dealing with the partnership. Dissolution and winding up of the partnership.

Definition of a Partnership Definition encompasses three distinct factors: an association of two or more persons to carry on as co-owners who attempt to make a profit. ABC Company A B

Definition of a Partnership What is a person? An individual A corporation Another partnership Z Corp T&D Partnership

Partnerships: Pros & Cons Advantages Ease of formation Lack of formality Single taxation (see following slide) Disadvantages Unlimited liability (for general partnerships) Difficulty in disposing of partnership interests Mutual agency

Partnership: Income Tax Reporting Single Taxation of Partnership Earnings Partnerships only report their earnings—they are not taxed at the business entity level (as are corporations). Partnerships file IRS Form 1065, which shows the allocation of profits among partners. Partners report their share of profits on their individual IRS Form 1040 return. Uncle Sam A B AB Partnership

Formation of a Partnership The partnership agreement Can be as informal as a handshake or as formal as a many-paged partnership agreement. Should include the following items: Name of partnership and names of partners Type of business to be conducted and duration Initial capital contributions Complete specification of profit or loss distribution Procedures used for partnership changes Other aspects of operations

Practice Quiz Question #1 Which of the following is not one of the advantages of general partnerships? Ease of formation Unlimited liability Lack of formality Single taxation

Learning Objective 15-2 Understand and explain the differences among different types of partnerships.

Types of Partnerships General Partnerships All partners have unlimited liability. Creditors can go after the personal assets of any or all of the partners.

Types of Partnerships Limited Partnerships Have at least one general partner and one or more limited partners. General partner is personally liable for the partnership’s obligations and has management responsibility. Limited partners are liable only to the extent of their capital contribution but do not have any management authority. Typically use the equity method to account for their investments.

Types of Partnerships Limited Liability Partnerships (LLPs) Each partner has some degree of liability shield. No general or limited partners. Partners are not personally liable for a partnership obligation. Virtually all large public accounting firms are LLPs.

Types of Partnerships Limited Liability Limited Partnerships (LLLPs) In most states, a LP may elect to become a LLLP. Each partner in an LLLP is liable only for the business obligations of the partnership, not for acts of malpractice or other wrongdoing by the other partners in the normal course of the partnership’s business. An advantage of an LLLP is that general partners, even though responsible for management of the partnership, have no personal liability for partnership obligations, similar to the shield provided to limited partners.

Practice Quiz Question #2 Which of the following statements is true? The partners in a general partnership have limited liability. At least two of the partners in a limited partnership must be general partners. Partners in an LLP are not responsible for their own actions. Limited liability limited partnerships must have at least one general partner.

Learning Objective 15-3 Make calculations and journal entries for the formation of partnerships.

Accounting for Partnership Formation At the formation of a partnership, it is necessary to assign a proper value of the noncash assets and liabilities contributed by the partners. The partnership must clearly distinguish between capital contributions and loans made to the partnership by individual partners. ASC 820 requires contributed assets to be valued at their fair values, which may require appraisals or other valuation techniques. The individual partners must agree to the percentage of equity that each will have in the partnership’s net assets. The capital balance is generally determined by the proportionate share of each partner’s capital contribution. However, partners may agree to any proportional division of capital.

Illustration of Accounting for Partnership Formation Alt, a sole proprietor, has been developing software for several types of computers. The business has the following account balances as of December 31, 20X0:

Illustration of Accounting for Partnership Formation Alt needs additional technical assistance to meet the increasing sales and offers Blue an interest in the business. Alt and Blue agree to form a partnership. Alt’s business is audited, and its net assets are appraised. The audit resulted in the following adjustments to net assets of Alt’s business: Alt, a sole proprietor, has been developing software for several types of computers. The business has the following account balances as of December 31, 20X0: FMV of $9,000 FMV of $19,000 $1,000 missing

Illustration of Accounting for Partnership Formation Alt, a sole proprietor, has been developing software for several types of computers. The business has the following account balances as of December 31, 20X0: Alt needs additional technical assistance to meet the increasing sales and offers Blue an interest in the business. Alt and Blue agree to form a partnership. Alt’s business is audited, and its net assets are appraised. The audit resulted in the following adjustments to net assets of Alt’s business: FMV of $9,000 FMV of $19,000 $1,000 missing

Illustration of Accounting for Partnership Formation Alt and Blue prepare and sign a partnership agreement that includes all significant operating policies. Blue will contribute $10,000 cash for a one-third capital interest. The AB Partnership is to acquire all of Alt’s business and assume its debts. The entry to record the initial capital contribution on the partnership's books is: Alt, a sole proprietor, has been developing software for several types of computers. The business has the following account balances as of December 31, 20X0: $3,000 (Alt)+ $10,000 (Blue) FMV of $9,000 (Alt) FMV of $19,000 (Alt) $10,000 +$1,000 missing (Alt) (A-L)*2/3 = [$41,000 - $11,000] * 2/3 (A-L)*1/3 = [$41,000 - $11,000] * 1/3 *No Accumulated Depreciation is carried forward to partnership *All liabilities are recognized and recorded

Partnership Formation Example Brian and Spencer wish to form the B&S partnership. Brian contributes land with a book value of $65,000 and a current value of $150,000 and a building with a book value of $142,000 and a current value of $175,000. Spencer will contribute cash. If the partners plan to share profits and losses equally after the formation of the partnership and assuming they have agreed to equal capital contributions, how much cash will Spencer have to contribute to form the partnership?

Comprehensive Partnership Creation Problem The partnerships of Brad & Mike (B&M) and Austin and Justin (A&J) began business on 1/1/X1; each partnership owns one retail appliance store. The two partnerships agree to combine as of 7/1/X8 to form a new partnership, BAM-J Discount Stores. REQUIRED Given the information on the next two slides, Prepare the journal entries to record the initial capital contribution after considering the effect of this information. Use separate entries for each of the combining partnerships. Prepare a schedule computing the cash contributed or withdrawn by each partner to bring the initial capital balances into the profit and loss sharing ratio.

Comprehensive Partnership Creation Problem Profit and loss ratios. The profit and loss sharing ratios for the former partnerships were 40% to Brad and 60% to Mike, and 30% to Austin and 70% to Justin. The profit and loss sharing ratio for the new partnership is Brad, 20%; Mike, 30%; Austin, 15%; and Justin, 35%. Capital investments. The opening capital investments for the new partnership are to be in the same ratio as the profit and loss sharing ratios for the new partnership. If necessary, certain partners may have to contribute additional cash, and others may have to withdraw cash to bring the capital investments into the proper ratio. Accounts receivable. The partners agreed to set the new partnership’s allowance for bad debts at 3% of the accounts receivable contributed by B&M and 12% of the accounts receivable contributed by A&J. Inventory. The new partnership’s opening inventory is to be valued by the FIFO method. B&M used the FIFO method to value inventory (which approximates its current value), and A&J used the LIFO method. The LIFO inventory represents 85% of its FIFO value. Property and equipment. The partners agree that the building’s current value is approximately 70% of the building’s historical cost, as recorded on each partnership’s books. Unpaid liability. After each partnership’s books were closed on 6/30/X8, an unrecorded merchandise purchase of $1,500 by A&J was discovered. The merchandise had been sold by 6/30/X8. The 6/30/X8 post-closing trial balances of the partnerships follow.

Comprehensive Partnership Creation Problem Account Brad & Mike Trial Balance – June 30, 20X8 Austin & Justin Trial Cash 25,000   22,000 Accounts Receivable 100,000 150,000 Allowance for doubtful accounts 2,000 6,000 Inventory 175,000 119,000 Building & Equipment 105,000 160,000 Accumulated Depreciation 24,000 61,000 Accounts Payable 40,000 60,000 Notes Payable 120,000 Brad, Capital 95,000 Mike, Capital 144,000 Austin, Capital 65,000 Justin, Capital 139,000 Totals 405,000 451,000 Prepare the journal entries to record the initial capital contribution after considering the effect of this information. Use separate entries for each of the combining partnerships. Prepare a schedule computing the cash contributed or withdrawn by each partner to bring the initial capital balances into the profit and los sharing ratio.

Comprehensive Problem Solution PART 1 Summary of changes to carrying values: Brad & Mike Austin & Justin Increase allowance for bad debt Increase inventory ) Increase buildings and equipment Increase accounts payable Net increase Allocate to: Brad (40%) Austin (30%) Mike (60%) Justin (70%)

Comprehensive Problem Solution Brad & Mike Journal Entry: Cash Accounts Receivable Allowance for doubtful accounts Inventory Building & Equipment Accounts Payable Notes Payable Brad, Capital Mike, Capital

Comprehensive Problem Solution Austin & Justin Journal Entry: Cash Accounts Receivable Allowance for doubtful accounts Inventory Building & Equipment Accounts Payable Notes Payable Austin, Capital Justin, Capital

Comprehensive Problem Solution PART 2 Brad Mike Austin Justin Total Profit sharing percentage 20% 30% 15% 35% Capital balances 91,600 138,900 71,150 153,350 455,000 Capital balances required using profit and loss sharing percentages 91,000 136,500 68,250 159,250 Capital contribution or (withdrawal) (600) (2,400) (2,900) 5,900

Learning Objective 15-4 Make calculations and journal entries for the operation of partnerships.

Accounting for Operations of a Partnership Partners’ accounts Capital accounts Used to record the initial investment of a partner, any subsequent capital contributions, profit or loss distributions, and any withdrawals of capital by the partner. Deficiencies are usually eliminated by additional capital contributions. Capital Investment Contributions % Loss % Profit Drawings 33

Accounting for Operations of a Partnership Partners’ accounts Drawing accounts Used to record periodic withdrawals and is then closed to the partner’s capital account at the end of the period. Noncash drawings are valued at their market values at the date of the withdrawal and the related gain or loss should be recognized by the partnership. Loan accounts A loan from a partner is shown as a payable on the partnership’s books, the same as any other loan. Unless all partners agree otherwise, these loans should bear interest, and the interest income should be recognized on the partnership’s income statement. 34

Practice Quiz Question #3 Which of the following would result in a reduction to a partner’s capital account? a. The initial investment. b. The allocation of a profit. c. Additional capital contributions. d. A withdrawal. e. A loan to a partner.

Learning Objective 15-5 Make calculations and journal entries for the allocation of partnership profit or loss.

Allocating Profit or Loss to Partners Four major profit distribution methods used by partnerships: Preselected ratio Interest on capital balances Salaries to partners Bonuses to partners

Allocating Profit or Loss to Partners Preselected ratios Usually the result of negotiations between the partners. Interest on capital balances The partners divide some or all of the income earned among themselves based on the relative balances they have maintained in their capital accounts. Salary Fixed amount of company profits allocated to a given partner. Bonus Portion of profits allocated to a partner based on a predetermined performance formula. Preselected ratio Interest on capital balances Salaries to partners Bonuses to partners

Illustration of Profit Allocation During 20X1, the AB Partnership earned $45,000 of revenue and incurred $35,000 in expenses, leaving a profit of $10,000 for the year. Alt maintains a capital balance of $20,000 during the year, but Blue’s capital investment varies during the year as follows: Alt, a sole proprietor, has been developing software for several types of computers. The business has the following account balances as of December 31, 20X0: Withdrawals Additional Investment

Illustration of Profit Allocation Arbitrary Profit-Sharing Ratio Alt and Blue share profits in a ratio of 60% to Alt and 40% to Blue (a 3:2 ratio). Using this ratio, how will the net income be distributed to each partner's capital account?

Illustration of Profit Allocation Arbitrary Profit Sharing – Journal Entries

Illustration of Profit Allocation Interest on Capital Balances Compute Blue’s weighted-average capital balance for 20X1.

Illustration of Profit Allocation Interest on Capital Balances Assuming Alt and Blue agree to allocate profits first based on 15% of weighted-average capital balances and then to any remaining profit based on a 60:40 ratio, how will the $10,000 profit be distributed between the partners?

Illustration of Profit Allocation Salaries Assume that the partnership agreement provides for fixed allocations of $2,000 to Alt and $5,000 to Blue. Any remainder is to be distributed in the profit and loss-sharing ratio of 60:40 percent. How will the $10,000 profit be distributed between the partners?

Illustration of Profit Allocation Bonuses Normally, a bonus is a percentage of income either (1) before or (2) after subtracting the bonus. Assume a bonus of 10% of income in excess of $5,000 is to be credited to Blue’s capital account before distributing the rest of the profit. What will be the bonus computation?

Illustration of Profit Allocation Bonuses Normally, a bonus is a percentage of income either (1) before or (2) after subtracting the bonus. Assume a bonus of 10% of income in excess of $5,000 is to be credited to Blue’s capital account after distributing the rest of the profit. What will be the bonus computation?

Illustration of Profit Allocation Bonuses Assume that the partnership agreement provides a bonus of 10% income in excess of $5,000, after subtracting the bonus, before distributing the remaining profit by a profit and loss-sharing ratio of 60:40. How will the $10,000 profit be distributed between the partners?

Multiple Profit Allocation Bases A partnership agreement may provide a formula describing several allocation procedures to be used to distribute profit. Example: a combination of preselected ratios, interest on capital balances, salaries to partners, and bonuses to partners. The partnership agreement should also specify the order that these different methods should be implemented.

Multiple Profit Allocation Bases – Example During 20X1, AB Partnership earned $45,000 of revenue and incurred $35,000 in expenses, leaving a profit of $10,000 for the year. Assume that the AB partnership profit and loss agreement specifies the following allocation process: Interest of 15% on weighted-average capital balances. Salaries of $2,000 for Alt and $5,000 for Blue. A bonus of 10% of profits to be paid to Blue on partnership income exceeding $5,000 before subtracting the bonus, partners’ salaries, and interest on capital balances. Any residual to be allocated in the ratio of 60% to Alt and 40% to Blue. Using this allocation process, how will the net income be distributed to each partner’s capital accounts?

Multiple Profit Allocation Bases – Step 1 Step 1: Interest of 15% on weighted-average capital balances. Assume that Alt maintains a capital balance of $20,000 during the year, but Blue’s capital investment varies during the year as follows:

Multiple Profit Allocation Bases – Step 1 Step 1: Interest of 15% on weighted-average capital balances. Compute Blue’s weighted-average capital balance for 20X1.

Multiple Profit Allocation Bases – Step 1 Step 1: Interest of 15% on weighted-average capital balances.

Multiple Profit Allocation Bases – Step 2 Step 2: Salaries of $2,000 for Alt and $5,000 for Blue.

Multiple Profit Allocation Bases – Step 3 Step 3: A bonus of 10% of profits to be paid to Blue on partnership income exceeding $5,000 before subtracting the bonus, partners’ salaries, and interest on capital balances.

Multiple Profit Allocation Bases – Step 4 Step 4: Any residual to be allocated in the ratio of 60% to Alt and 40% to Blue.

Group Exercise 1: Allocating Profit and Loss, No Restrictions The partnership of Alex and James has the following provisions: Alex and James receive salary allowances of $37,000 and $18,000, respectively. Interest is imputed at 10% on the average capital investment. Any remaining profit or loss is shared between Alex and James in a 3:2 ratio, respectively. Average Capital investments: Alex, $50,000; James, $130,000. REQUIRED 1. Prepare a schedule showing how the profit would be divided, assuming the partnership profit or loss is: a. $ 102,000 b. $ 57,000 c. $(34,000) 2. What journal entry should be made to allocate the profit or loss for each of the three cases listed above?

Group Exercise 1: Solution for part a ALLOCATED TO Alex James Total Total Profit Salary Interest on Capital Residual Profit Allocate Profit

Group Exercise 1: Allocating Profit and Loss, No Restrictions The partnership of Alex and James has the following provisions: Alex and James receive salary allowances of $37,000 and $18,000, respectively. Interest is imputed at 10% on the average capital investment. Any remaining profit or loss is shared between Alex and James in a 3:2 ratio, respectively. Average Capital investments: Alex, $50,000; James, $130,000. REQUIRED 1. Prepare a schedule showing how the profit would be divided, assuming the partnership profit or loss is: a. $ 102,000 b. $ 57,000 c. $(34,000) 2. What journal entry should be made to allocate the profit or loss for each of the three cases listed above?

Group Exercise 1: Solution for part b ALLOCATED TO Alex James Total Total Profit Salary Interest on Capital Residual Profit Allocate Profit

Group Exercise 1: Allocating Profit and Loss, No Restrictions The partnership of Alex and James has the following provisions: Alex and James receive salary allowances of $37,000 and $18,000, respectively. Interest is imputed at 10% on the average capital investment. Any remaining profit or loss is shared between Alex and James in a 3:2 ratio, respectively. Average Capital investments: Alex, $50,000; James, $130,000. REQUIRED 1. Prepare a schedule showing how the profit would be divided, assuming the partnership profit or loss is: a. $ 102,000 b. $ 57,000 c. $(34,000) 2. What journal entry should be made to allocate the profit or loss for each of the three cases listed above?

Group Exercise 1: Solution for part c ALLOCATED TO Alex James Total Total Profit Salary Interest on Capital Residual Profit Allocate Profit

When a “limit” provision exists: Methods to Share Profits and Losses: “To the Extent Possible” Limitations When a “limit” provision exists: The next lower level method of sharing can be reached if and only if there is still unallocated profit remaining after dealing with the current level.

Group Exercise 2: Allocating Profit and Loss—“Limit” Assume the same information provided in Group Exercise 1, except that the partnership agreement stipulates the following order of priority: Salary allowances (only to the extent available). Imputed interest on average capital investments (only to the extent available). Any remaining profit in a 3:2 ratio. (No mention is made regarding losses.) REQUIRED: The requirements are the same as for Group Exercise 1 (i.e., calculate the allocations and prepare journal entries). a. $ 102,000 b. $ 57,000 c. $ (34,000)

Group Exercise 2: Solution for part a ALLOCATED TO Alex James Total Total Profit Salary Interest on Capital Residual Profit Allocate Profit

Group Exercise 2: Allocating Profit and Loss—“Limit” Assume the same information provided in Group Exercise 1, except that the partnership agreement stipulates the following order of priority: Salary allowances (only to the extent available). Imputed interest on average capital investments (only to the extent available). Any remaining profit in a 3:2 ratio. (No mention is made regarding losses.) REQUIRED: The requirements are the same as for Group Exercise 1 (i.e., calculate the allocations and prepare journal entries). a. $ 102,000 b. $ 57,000 c. $ (34,000)

Group Exercise 2: Solution for part b ALLOCATED TO Alex James Total Total Profit Salary Interest on Capital * Residual Profit Allocate Profit * $2,000 x (5,000 ÷ $18,000) = 556 $2,000 x ($13,000 ÷ $18,000) = 1,444

Group Exercise 2: Solution for part c In this case, the partnership agreement is vague. An argument can be made for allocating the loss equally pursuant to UPA 1997 because the partnership agreement is silent with respect to losses. Alternatively, we could presume that losses were intended to be shared in the residual profit- sharing ratio. In these cases, the accountant should seek clarification from each partner.

Practice Quiz Question #4 Matt and Chad created a partnership (M&C) on 12/31/X8 (sharing profits 50/50). Matt contributed equipment from his sole proprietorship having a carrying value of $4,000 and a fair value of $8,000. In 20X9, M&C had profits of $96,000 and borrowed $20,000 from a bank. In 2009, Matt withdrew $35,000 cash. Matt’s Y/E capital balance is a. $11,000. b. $17,000. c. $21,000. d. $56,000.

Learning Objective 15-6 Make calculations and journal entries to account for changes in partnership ownership.

New Partner Purchases Partnership Interest Directly from an Existing Partner An individual may acquire a partnership interest directly from one or more of the existing partners. Cash or other assets are exchanged outside the partnership. The only entry necessary on its books is a reclassification of the partnership’s total capital. C Interest $ A B AB Partnership

New Partner Invests in Partnership A new partner may acquire a share of the partnership by investing in the business. In this case, the partnership receives the cash or other assets: AB Partnership A B ABC Partnership A B C C Assets + =

New Partner Invests in Partnership Three possible cases when a new partner invests in a partnership: Case 1: new partner’s investment = new partner’s proportion of the partnership’s book value. Case 2: new partner’s investment > new partner’s portion of the partnership’s book value. This indicates that the partnership’s prior net assets are undervalued on the books or that unrecorded goodwill exists. Case 3: new partner’s investment < new partner’s portion of the partnership’s book value. This suggests that the partnership’s prior net assets are overvalued on its books or that the new partner may be contributing goodwill in addition to other assets.

New Partner Invests in Partnership Formula for computing the new partner’s proportion of the partnership’s net book value: New partner’s proportion of the partnership’s net book value Prior capital of existing partners = x Percentage of capital to new partner Investment of new partner +

New Partner Invests in Partnership Consider the following facts: The January 1, 20X3, capital of the AB Partnership is $30,000. Alt’s balance is $20,000, and Blue’s balance is $10,000. Alt and Blue share profits in the ratio of 60:40. Cha is invited into the partnership. Cha will have a 25% capital interest and a 25% share of the profits. Alt and Blue will share the remaining 75% of profits in the ratio of 60:40, resulting in Alt having a 45% share of any profits and Blue having a 30% share. 75% x 60% $75% x 40%

New Partner Invests in Partnership – Case 1 Case 1: Investment equals proportion of the partnership’s book value. Assume Cha invests $10,000 into the partnership. Investment in partnership $10,000 New partner’s proportionate book value: (10,000) Difference (Investment = Book Value) $0 $10,000 ($30,000 = x 0.25 $10,000) + New partner’s proportion of the partnership’s net book value Prior capital of existing partners = x Percentage of capital to new partner Investment of new partner +

New Partner Invests in Partnership – Case 1 Case 1: Investment equals proportion of the partnership’s book value. Assume Cha invests $10,000 into the partnership.

New Partner Invests in Partnership – Case 2 Case 2: New partner investment > new partner’s proportion of the partnership’s book value. Assume Cha invests $11,000 into the partnership. Investment in partnership $11,000 New partner’s proportionate book value: (10,250) Difference (Investment > Book Value) $750 $10,250 ($30,000 = x 0.25 $11,000) + New partner’s proportion of the partnership’s net book value Prior capital of existing partners = x Percentage of capital to new partner Investment of new partner +

New Partner Invests in Partnership – Case 2 Case 2: New partner investment > new partner’s proportion of the partnership’s book value. Assume Cha invests $11,000 into the partnership. Investment in partnership $11,000 New partner’s proportionate book value: (10,250) Difference (Investment > Book Value) $750 Two alternative accounting treatments can be used in this case: Revaluation method Bonus method

New Partner Invests in Partnership – Case 2 Revaluation method: Increase the book values of existing net assets to their market values. Record unrecognized goodwill. Increase the existing partners’ capital accounts for their respective shares of the increase in the book values of the net assets and the recorded goodwill. The partnership’s total resulting capital reflects the existing capital balances plus the amount of asset revaluation plus the new partner’s investment. Excess Value Book Value of Net Assets

New Partner Invests in Partnership – Case 2 Case 2 with revaluation method: Cha invests $11,000 into the partnership. Assume that Cha paid a $750 excess over her proportionate book value because the partnership owns land on which it has constructed warehouse buildings. The land has a book value of $4,000, but a recent appraisal indicates that it has a market value of $7,000. Land = Small Pie =

New Partner Invests in Partnership – Case 2 Case 2 with revaluation method: The increase in land value is allocated to the partners’ capital accounts in the profit and loss ratio that existed during the time of the increase. The partnership makes the following entry for the revaluation of the land: Land = Small Pie =

New Partner Invests in Partnership – Case 2 Case 2 with revaluation method: Cha’s $11,000 investment brings the partnership’s total resulting capital to $44,000, as follows: Land = Small Pie =

New Partner Invests in Partnership – Case 2 Case 2 with revaluation method: Cha is acquiring a 25% interest in ABC Partnership’s total resulting capital. Her capital credit, after revaluing the land, is calculated as follows: Land = Small Pie = New partner’s proportion of the partnership’s net book value Prior capital of existing partners = x Percentage of capital to new partner Investment of new partner + $11,000 ($30,000 + 0.25 $3,000 + $11,000) Cha’s share of total resulting capital

New Partner Invests in Partnership – Case 2 Case 2 with revaluation method: The entry to record Cha’s admission into the partnership follows: Land = Small Pie =

New Partner Invests in Partnership – Case 2 Case 2 with goodwill method: Cha is investing $11,000 for a 25% interest; therefore, she must believe the total resulting partnership capital is $44,000 ($11,000 / 0.25). The estimated goodwill is $3,000. Land = Small Pie =

New Partner Invests in Partnership – Case 2 Case 2 with goodwill method: The estimated goodwill is calculated as follows: Land = Small Pie =

New Partner Invests in Partnership – Case 2 Case 2 with goodwill method: The entries to record goodwill and the admission of Cha are as follows: Land = $ Small Pie =

New Partner Invests in Partnership – Case 2 Bonus method: A transfer of capital balances among the partners. Used when the partners do not wish to record adjustments in asset and liability accounts or recognize goodwill. The size of the pie stays the same (the book value of existing equity plus the contribution of the new partner), but one or more partners will give some of his or her “slice” to the other partners. Book Value of Net Assets

New Partner Invests in Partnership – Case 2 Case 2 with bonus method: Record a portion of the new partner’s investment as a bonus to the existing partners to align the capital balances properly at the time of the new partner’s admission. The $750 excess Cha is paid is a bonus allocated to the original partners in their profit and loss ratio of 60% to Alt and 40% to Blue. ABC’s total resulting capital consists of $30,000 existing capital plus the $11,000 investment of Cha. No additional capital is recognized by revaluing assets. Small Pie =

New Partner Invests in Partnership – Case 2 Case 2 with bonus method: New partner’s proportion of the partnership’s net book value Prior capital of existing partners = x Percentage of capital to new partner Investment of new partner + $10,250 ($30,000 + 0.25 $11,000) Cha’s share of total resulting capital Small Pie =

New Partner Invests in Partnership – Case 2 Case 2 with bonus method: Small Pie =

New Partner Invests in Partnership – Case 2 Key concepts from Case 2:

New Partner Invests in Partnership – Case 3 Case 3: New partner investment < new partner’s proportion of the partnership’s book value. Assume Cha invests $8,000 into the partnership. Investment in partnership $8,000 New partner’s proportionate share of book value: (9,500) Difference (Investment < Share of book value) ($1,500) $9,500 ($30,000 = x 0.25 $8,000) + New partner’s proportion of the partnership’s net book value Prior capital of existing partners = x Percentage of capital to new partner Investment of new partner +

New Partner Invests in Partnership – Case 3 Case 3: New partner investment < new partner’s proportion of the partnership’s book value. Assume Cha invests $8,000 into the partnership. Investment in partnership $8,000 New partner’s proportionate book value: (9,500) Difference (Investment < Book Value) ($1,500) Two alternative accounting treatments can be used in this case: Revaluation / Goodwill Method Bonus Method

New Partner Invests in Partnership – Case 3 Revaluation method: Decrease book values of net assets to recognize the reduction in their values. Decrease the original partners’ capital accounts for their respective share of the decrease in the values of the net assets. Record goodwill or other intangible benefits brought in by the new partner and record the increase in the new partner’s capital account. Recognize that the partnership’s total resulting capital reflects the prior capital balances less the amount of the net asset valuation write-down plus the new partner’s investment and new goodwill. Excess Value Book Value of Net Assets

New Partner Invests in Partnership – Case 3 Case 3 with revaluation method: Assume the reason Cha paid only $8,000 for a 25% interest in the partnership is that equipment used in current production is recorded at a book value of $14,000 but has a fair value of only $8,000. The partners agree to recognize the impairment loss and write down the equipment to its fair value before the new partner’s admission. The write-down is allocated to the original partners in the profit and loss ratio that existed during the period of the decline in the equipment’s fair value: 60% to Alt and 40% to Blue. Equipment = ( ) Small Pie =

New Partner Invests in Partnership – Case 3 Case 3 with revaluation method: The write-down is recorded as follows: Small Pie = Equipment = ( )

New Partner Invests in Partnership – Case 3 Case 3 with revaluation method: Cha’s value in the partnership’s total resulting capital after the write-down is: Small Pie = Equipment = ( ) Small Pie Equipment Write-down Cha’s ownership %

New Partner Invests in Partnership – Case 3 Case 3 with revaluation method: The entry to record the admission of Cha as a partner in the ABC Partnership is as follows: Small Pie = Equipment = ( )

New Partner Invests in Partnership – Case 3 Case 3 with goodwill method: Assume the $1,500 difference in payment by Cha is due to her essential business experience, skills, customer contacts, reputation, or other aspects of goodwill that she will bring to the partnership. Therefore, the partnership agrees that she should get a 25% interest in the partnership for her contribution of $8,000 cash and goodwill. Small Pie = Goodwill = ( )

New Partner Invests in Partnership – Case 3 Case 3 with goodwill method: The amount of goodwill the new partner brings in may be estimated from the amount of the total capital being retained by the original partners. In this case, they are retaining a 75% interest in the partnership. The amount of goodwill that Cha brought into the partnership is determined as follows: Small Pie = Goodwill = ($ )

New Partner Invests in Partnership – Case 3 Case 3 with goodwill method: Cha’s value in the partnership’s total resulting capital after Cha’s contributions is: Small Pie = Goodwill = ($6,000) ($30,000 + $8,000 + $2,000) * 25% = $10,000

New Partner Invests in Partnership – Case 3 Case 3 with goodwill method: The entry to record Cha’s admission into the ABC Partnership is: Small Pie = Goodwill = ($6,000)

New Partner Invests in Partnership – Case 3 Bonus method: A transfer of capital balances among the partners. Used when the partners do not wish to record adjustments in asset and liability accounts or recognize goodwill. The size of the pie stays the same (the book value of existing equity plus the contribution of the new partner), but one or more partners will give some of his or her “slice” to the other partners. Book Value of Net Assets

New Partner Invests in Partnership – Case 3 Case 3 with bonus method: Cha’s admission as a new partner with a 25% interest in the ABC Partnership for an investment of only $8,000 may be accounted for by recognizing a bonus the original partners give Cha. The $1,500 bonus is the difference between Cha’s $9,500 book value and her $8,000 investment. The original partner’s capital accounts are reduced by $1,500 in their profit and loss ratios, and Cha’s capital account is credited for $9,500. Small Pie = 30,000 + 8,000 = 38,000

New Partner Invests in Partnership – Case 3 Case 3 with bonus method: The admission of Cha to the partnership would be recorded with the following journal entry: Small Pie = 30,000 + 8,000 = 38,000

New Partner Invests in Partnership – Case 3 Case 3 with bonus method: Cha’s value in the partnership’s total resulting capital after being given the bonus is: Small Pie = 30,000 + 8,000 = 38,000 Small Pie Cha’s ownership %

New Partner Invests in Partnership – Case 2 Key concepts for Case 3:

Practice Quiz Question #5a Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). The old partners capital accounts are not to decrease (i.e., use the Revaluation / Goodwill method). Betsy’s capital account is credited: $ 9,000 $54,000 $58,500 $60,000 $76,500

The BIG PIE (BV of NA + Goodwill) Solution, Summary New implied value: $ 54,000 ÷ 25% = $ 216,000 Old implied value: $ 180,000 ÷ 75% = $ 240,000 BV of net assets: $ 180,000 + $54,000 = $ 234,000 Implied Goodwill = $ 240,000  $234000 = $ 6,000 Goodwill belongs to partner Since we’re revaluing, use the pie: x 25% = GW = The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only)

Practice Quiz Question #5b Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). Use the Bonus Method. Betsy’s capital account is credited $ 9,000. $54,000. $58,500. $60,000. $76,500.

The BIG PIE (BV of NA + Goodwill) Solution, Summary New implied value: $ 54,000 ÷ 25% = $ 216,000 Old implied value: $ 180,000 ÷ 75% = $ 240,000 BV of net assets: $ 180,000 + $54,000 = $ 234,000 Implied Goodwill = $ 240,000  $234,000 = $ 6,000 Goodwill belongs to partner Since we’re not revaluing, use the Small pie: The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only) Small Pie = + = x 25% =

Group Exercise: Goodwill Method Scott and Stephanie are partners with capital balances of $100,000 and $65,000, and they share profits and losses in the ratio of 3:2, respectively. Zoe invests $60,000 cash for a 25% interest in the capital and profits of the new partnership. The partners agree that the implied partnership goodwill is to be recorded simultaneously with the admission of Zoe. REQUIRED Calculate the firm’s total implied goodwill. Prepare the entry or entries to record the admission of Zoe.

The BIG PIE (BV of NA + Goodwill) Solution, Summary New implied value: $ 60,000 ÷ 25% = $ 240,000 Old implied value: $ 165,000 ÷ 75% = $ 220,000 BV of net assets: $ 165,000 + $60,000 = $ 225,000 Implied Goodwill = $ 240,000  $225,000 = $ 15,000 Goodwill belongs to partners The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only)

Group Exercise: Goodwill Method Solution Entry to record Goodwill Entry to record Zoe’s cash contribution x 25% = GW = Note that this is 25% of the “Big Pie” because we revalue the balance sheet!

Group Exercise: Bonus Method Jim and June are partners who share profits and losses in the ratio of 2:1, respectively. On 12/31/X8 their capital accounts are as follows: Jim $ 40,000 June 30,000 Total $ 70,000 On that date, they agreed to admit Mel as a partner with a 30% interest in the capital and profits and losses for an investment of $15,000. The new partnership will begin with total capital of $85,000. REQUIRED Prepare the entry or entries to record the admission of Mel.

The BIG PIE (BV of NA + Goodwill) Solution, Summary New implied value: $ 15,000 ÷ 30% = $ 50,000 Old implied value: $ 70,000 ÷ 70% = $ 100,000 BV of net assets: $ 70,000 + $15,000 = $ 85,000 Implied Goodwill = $ 100,000  $85,000 = $ 15,000 Goodwill belongs to new partner (because $50,000 is less than $100,000) Implies that he “gave” less for his relative share of the business. The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only) Note that we use the small pie here with bonus method.

Group Exercise: Goodwill Method Solution Entry to record admission of Mel x 30% = Small Pie = Note that this is 30% of the “Small Pie” because we don’t revalue the balance sheet! Note: The bonus to the new partner is shared between the old partners in their old profit and loss sharing ratio of 2:1.

Comprehensive Group Problem Jenn and Amanda are in partnership—they share profits and losses in the ratio of 7:1, respectively, and they have capital balances of $30,000 each. The partnership’s land has a fair value of $30,000 in excess of book value. Tommy is admitted into the partnership for a cash contribution of $25,000. The new profit and loss sharing formula is Jenn, 70%, Amanda, 10%, and Tommy, 20%. The value of the partnership’s existing goodwill is agreed to be $10,000. REQUIRED Prepare the required entries, assuming the land is to be revalued and the goodwill is to be recorded on the partnership’s books. Prepare the required entries, assuming that the bonus method is to be used with respect to the undervalued existing assets and the goodwill. Note that this goodwill number is given because it is a bit harder to calculate when there is also unrecorded appreciation in existing assets. However, the next slide shows the calculation.

The BIG PIE (BV of NA + Goodwill) Solution, Summary New implied value: $ 25,000 ÷ 20% = $ 125,000 Old implied value: $ 60,000 ÷ 80% = $ 75,000 BV of net assets: $ 60,000 + $25,000 = $ 85,000 Total Excess Value = $ 125,000  $85,000 = $ 40,000 Goodwill = Total Excess Value – Excess Land Value Goodwill = $40,000 - $30,000 = $10,000 Goodwill belongs to the partners GW = 10,000 Land = 30,000 The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only)

Comprehensive Group Problem Solution PART 1 (Revaluation / Goodwill Method): To revalue existing assets to their current values. To record goodwill. To record cash contribution by Tommy. x 20% = GW = 10,000 Land = 30,000 Note that this is 20% of the “Big Pie.” 121

Comprehensive Group Problem Solution PART 2 (Bonus Method): If the partnership were sold one day after Tommy was admitted and the selling price was $40,000 more than the book value of the net assets, Tommy would share in the $40,000 gain to the extent of $8,000 (20% × $40,000), the amount of his capital contribution that is given as a bonus to Jenn and Amanda. x 20% = Small Pie = Note that this is 20% of the “Small Pie” without revaluing the land ($60,000 + $25,000). Note: The bonus to be given the old partners is Tommy’s profit and loss sharing percentage of 20% multiplied by the sum of the undervalued existing assets ($30,000) and the goodwill ($10,000). 122

Determining a New Partner’s Investment Cost Assume the following example: Alt and Blue wish to admit Cha into their partnership for a 25% interest. The original partnership capital is $30,000. Alt and Blue agree that the partnership’s assets should be revalued by recognizing a $3,000 increase in land value. How much should they ask Cha to invest into the partnership for the 25% interest?

Determining a New Partner’s Investment Cost 75% of total resulting capital $33,000 ÷ 0.75 Total resulting capital (100%) $44,000 Less existing partners’ capital (33,000) Cash contribution required of new partner $11,000 Total capital interest after $3,000 revaluation (before admitting Cha) Total capital interest after $3,000 revaluation (after admitting Cha)

Determining a New Partner’s Investment Cost Assume the following example: Assume, Alt and Blue wish to invite Cha into their partnership for a 25% interest. The original partnership capital is $30,000. Alt and Blue agree to give Cha a $1,500 bonus for joining the partnership. How much should they ask Cha to invest into the partnership for the 25% interest?

Determining a New Partner’s Investment Cost Prior capital of Alt and Blue $30,000 Less bonus given to Cha upon admission (1,500) Capital retained by Alt and Blue (75%) $28,500 Total resulting capital (100%) $38,000 Less original partners’ capital (28,500) Capital credit required of new partner $9,500 Less bonus to new partner from original partners (1,500) Cash contribution required of new partner $8,000 $28,500 ÷ .75 (Total capital interest after including bonus and after admitting Cha) Deducted since Cha will not be expected to pay this part of the investment cost (bonus)

Legal Aspects: Joining a Partnership A major risk of joining an existing partnership is the general practice of requiring the new partner to become jointly responsible for all pre-existing partnership liabilities, and all pre-existing contingent liabilities.

Legal Aspects: Withdrawing from a Partnership A partner that withdraws from a partnership is still responsible for the following items that exist at the time of the withdrawal all partnership obligations, and all contingent liabilities. Only creditors can expressly release a partner from this responsibility. In most cases, the partnership purchases the dissociated partner’s interest in the partnership for a buyout price.

Legal Aspects: Withdrawing from a Partnership Disassociation A broad term that refers to when a partner is no longer associated with a partnership. Dissolution A narrow term that refers to when a (1) partnership is dissolved, and (2) its affairs must be wound up. Thus, the partnership’s existence is terminated.

Practice Quiz Question #6 Upon withdrawal from a partnership, Cliff received $14,000 cash in excess of his capital balance. Cliff’s share of profits and losses was 20%. Partnership land was undervalued by $50,000. The total partnership goodwill is $ 4,000. $20,000. $24,000 $70,000.

Group Exercise: Retirement The 6/30/X8 balance sheet of the partnership of Sandy, Rees, and Raymond as follows. The partners share profits and losses in the ratio of 2:2:6, respectively. Assets at cost $145,000 Liabilities 26,000 Capital, Sandy 20,000 Capital, Rees 37,000 Capital, Raymond 62,000 Sandy retires from the partnership. By mutual agreement, the assets are to be adjusted to their fair value of $150,000 at 6/30/X8. Rees and Raymond agree that the partnership will pay Sandy $45,000 cash for her partnership interest. No goodwill is to be recorded. REQUIRED Prepare the entry to record the revaluation of assets to fair value. Prepare the entry to record Sandy’s retirement. What is the implicit total goodwill for the partnership?

Group Exercise Solution PART 1 To revalue assets to their current value. PART 2 To record the withdrawal of Sandy. PART 3 132

Conclusion The End