Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Chapter 16 Partnerships – Formation, Operations, and Changes in Ownership Interests Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1

Partnerships: Objectives Comprehend the legal characteristics of partnerships. Understand initial investment valuation and record keeping. Grasp the diverse nature of profit and loss sharing agreements and their computation. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Partnerships: Objectives (cont.) Value a new partner's investment in an existing partnership. Value a partner's share upon retirement or death. Understand limited liability partnership characteristics. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

1: partnership characteristics Partnerships – Formation, Operations, and Changes in Ownership Interests 1: partnership characteristics Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Partnerships RUPA "Revised Uniform Partnership Act“ Has been adopted by most states Entity theory: partners own their share of the partnership, but not its individual assets Dissociation: partners can dissociate without dissolution of the partnership Partners have Mutual agency – the ability to legally bind the partnership Unlimited liability – liable for partnership debts, including the use of personal assets Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Articles of Partnership The partnership agreement should specify: Products or services, line of business Partner rights and responsibilities Initial investment and value assigned to noncash investments Additional investment conditions Asset withdrawals Profit and loss sharing Dissolution procedures Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Reporting Financial reporting should provide for the needs of Partners Creditors of the partnership IRS – partnerships do not pay federal income taxes, but partnership tax returns allow the IRS to verify that each partner pays income taxes on their share of partnership income Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Partnerships – Formation, Operations, and Changes in Ownership Interests 2: initial investment Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Initial Investment A partnership is started by Amy and Paul, each investing cash. Cash XXX Amy Capital Paul Capital If Paul invests other assets, the value of those assets should be agreed upon in advance. Cash XXX Equipment Land Paul Capital Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Bonus or Goodwill on Initial Investment Partner initial investments may not represent ownership percentage. Partners may bring Individual talent Business connections Customer base Intellectual know-how Partners choose method to record their capital Bonus method Adjustment within the capital accounts Goodwill method Goodwill is recorded on the books Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Initial Investment with Bonus Total fair value received is split, as desired, between partner capital accounts. For example: Amy invests land and building worth $10 and $40, and Paul invests cash and inventory at $7 and $35. They agree to have equal shares: (10 + 40 + 7 + 35) / 2 = $46 each Cash 7 Inventory 35 Land 10 Building 40 Amy Capital 46 Paul Capital Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Initial Investment with Goodwill The partner contributing the greater fair value sets the implied value of the partnership, and goodwill is recorded to make up the difference for the partner who invested the lesser amount. In the Amy and Paul partnership: Amy's: (10 + 40) / 50% = $100 Paul's: (7 + 35) / 50% = $84 Use Amy’s investment to determine implied value of firm -- $100. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Initial Entry with Goodwill Paul's 50%($100) $50 He invests: Cash $7 Inventory $35 $42 Goodwill $8 Amy's 50%($100) $50 She invests: Land $10 Building $40 $50 Land 10 Building 40 Amy Capital 50 To record Amy's investment Cash 7 Inventory 35 Goodwill 8 Paul Capital To record Paul's investment and goodwill Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Additional Partner Transactions Each partner has his/her own accounts for Capital (the balance of a partner’s equity) Drawings (periodic amounts, similar to a salary) Withdrawals (other large or unusual amounts) Additional investments increase Capital. Drawings and withdrawals reduce Capital. Income Summary (Revenue and Expense Summary) is closed to Capital. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Sample Partner Closing Entries Amy Capital XXX Amy Drawings XX Amy Withdrawals Reduces Amy's capital for drawings and withdrawals Paul Capital Paul Drawings Income Summary Profit To share profits between Amy and Paul Drawings / withdrawals are closed to individual capital accounts. Income is shared between the partners. A loss would cause the entry to be reversed. It is possible for some partners to have losses overall while others have profits. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Statement of Partners' Capital Beginning capital + investments – drawings and/or withdrawals + income or – loss = ending capital Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

3: profit and loss sharing agreements Partnerships – Formation, Operations, and Changes in Ownership Interests 3: profit and loss sharing agreements Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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, provided to partners who manage the partnership. Salary allowances are not expenses in the determination of partnership net income. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Allocating Income Partners’ allowances for bonus, salary and interest are allocated to them, whether or not sufficient profits exist. Remaining profits (or deficit) are then split according to the agreed-upon proportions. These are general procedures. The partnership articles provide the specific requirements. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Example: Sharing Profits Lot and Babel agree to share profits and losses: Lot and Babel have $60 and $30 salary allowances, respectively Babel has a bonus of 50% of profits in excess of $500 Each have interest allowances of 10% of beginning capital Lot Capital, 1/1 $400 Babel Capital, 1/1 $350 Remaining profits or losses are shared Lot 60%, Babel 40% Partnership profits are $660 for the year. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Example: Sharing Profits (cont.)   Total Lot Babel Net income $660 Salary allowance (90) $60 $30 Bonus allowance (80) 80 Interest allowance (75) 40 35 Subtotal $415 Split 60:40 (415) 249 166 Allocated net income $0 $349 $311 Bonus = 50%(660 - 500) = 80 Lot Interest = 10%(400) = 40 Babel Interest = 10%(350) = 35 Allocation: 60%(415) = 249; 40%(415) = 166 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Example: Sharing Profits (cont.) Assume instead that income was only $180.   Total Lot Babel Net income $120 Salary allowance (90) $60 $30 Bonus allowance Interest allowance (75) 40 35 Subtotal, deficit ($45) Split 60:40 45 (27) (18) Allocated net income $0 $73 $47 Bonus = zero (income does not exceed $500) Lot Interest = 10%(400) = 40 Babel Interest = 10%(350) = 35 Allocation: 60%(-45) = -27; 40%(-45) = -18 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

4: admitting a new partner Partnerships – Formation, Operations, and Changes in Ownership Interests 4: admitting a new partner Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Admitting a New Partner There are three methods of entry for a new partner into an existing partnership: A current partner assigns interest to new partner. New partner purchases interest from existing partner. Goodwill method Bonus method New partner invests directly in partnership. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Assignment Assignment gives the assignee the right to a share of future earnings and share of assets in liquidation Not a partner No share in management Old Partner Capital XXX Assignee Capital Note that this means one partner can not make the decision to admit a new partner into the partnership, only to legally assign the financial rights of ownership. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Buy from Partner: Simple Abby and Bing have capital balances of $50 each and each have a 50% interest in the firm. Cobb buys half of Abby's interest for $25. Abby Capital 25 Cobb Capital   Before After Capital Share Abby $50 50% $25 25% Bing 50 Cobb 25 Total $100 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Buy from Partner: Goodwill Dawn and Ed have capital of $50 and $40, each with 50% interest. Fay will pay $60 directly to the partners and receive 50% interest in the firm. Dawn and Ed each keep 25%. Assets are at fair value. The goodwill increases Dawn & Ed's capital by $15 each. Implied value of firm, $60/.50 120 Old capital, $50 + 40 90 Goodwill 30 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Buy from Partner: Goodwill (cont.)   Before Revaluation After revaluation Transfer Final Dawn $50 $15 $65 ($35) $30 Ed 40 15 55 (25) 30 Fay 60  60 Total $90 $120 Presumably, Fay paid $35 to Dawn and $25 to Ed. If the partners had not wanted to realign the capital, the capital of Dawn and Ed would each be reduced by $30 to transfer the $60 to Fay. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Buy from Partner: Bonus If Dawn and Ed had decided not to revalue the assets or record goodwill, the bonus method is used. Fay's capital is 50%(90) = $45. Dawn and Ed Capital accounts are adjusted to their new balances 25%(90) = $22.5 Before Transfer Final Dawn $50 ($27.5) $22.5 Ed 40 (17.5) 22.5 Fay   45.0  45.0 Total $90 $90.0 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Entries for Purchase from Partner Entries for Fay's admission, under goodwill and bonus methods: Goodwill 30 Dawn Capital 15 Ed Capital 35 25 Fay Capital 60 Goodwill method, aligning capital accounts Dawn Capital 27.5 Ed Capital 17.5 Fay Capital 45 Bonus method, aligning capital accounts Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

New Partner Investment: Goodwill to Old Partners Al and Bev each have capital balances of $40 and share equally in the firm. Cal will be admitted with an investment of $50 cash. All three will have equal shares, and net assets are at fair value. Goodwill will be recorded. Implied value of firm, $50/(1/3)   $150 Old capital, $40 + 40 $80 Additional investment 50 130 Goodwill $20 Cal: $130*1/3 = $43.3, but he pays $50 … so goodwill goes to old partners. Implied firm value is based on Cal's investment. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

New Partner Investment: Goodwill to Old Partners (cont.)   Before Re-valuation After re-valuation Investment Final Al $40 $10 $50 Bev 40 10 50 Cal Total $80 $100 $150 Capital of $80 at the start, increases by the $20 goodwill and the $50 cash investment. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

New Partner Investment: Goodwill to New Partner Al and Bev each have capital balances of $40 and share equally in the firm. Cal will be admitted with an investment of $50 cash. Cal will be given a 40% share; Al and Bev will each have 30%, and net assets are at fair value. Goodwill will be recorded. Implied value of firm, $80/(.60)   $133.3 Old capital, $40 + 40 $80 Additional investment 50 130.0 Goodwill $3.3 Cal: $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. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

New Partner Investment: Goodwill to New Partner (cont.)   Before Re-valuation After re-valuation Investment Final Al $40 $40.0 Bev 40 40.0 Cal $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. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

New Partner Investment: Bonus Al and Bev decide not to revalue the business assets, and Cal invests $50 cash in the business for a 1/3 interest. Cal's new capital = 1/3 of the total $140. Since he invests $50 cash for a $52 interest, the $2 bonus is transferred from the old partners. Before Investment Bonus Final Al $50 ($1) $49 Bev 40 (1) 39 Cal   2  52 Total $90 $140 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Entries for Investment in Business Entries for Cal's investment, under goodwill and bonus methods: Goodwill 20 Al Capital 10 Bev Capital Cash 60 Cal Capital Goodwill method, goodwill to old partners Cash 50 Al Capital 1 Bev Capital Cal Capital 52 Bonus method, bonus to new partner Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

5: Death or retirement of a partner Partnerships – Formation, Operations, and Changes in Ownership Interests 5: Death or retirement of a partner Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Dissociation Firm value, according to the Uniform Partnership Act, is the greater of Liquidation value Sales value as a going concern without the dissociated partner Payment to exiting partner may be 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 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Payment to Exiting Partner Mo, Nel, and Owen are partners with capital balances and profit-sharing percentages, shown respectively, as follows: Owen retires, and his partnership interest is paid out by the partnership. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Payment Equals Partner Capital Owen Capital 80 Cash The Mo, Nel, and Owen partnership would be dissolved. Mo and Nel could continue the partnership, but would need to establish a new partnership agreement if a partner’s retirement was not addressed in the original partnership agreement. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Payment Exceeds Partner Capital If Owen is paid $92,000 in final settlement of his partnership interest, the excess may be treated as A bonus to Owen, or Goodwill, in the amount of the excess, or A revaluation of partnership capital based on the fair value implied by the excess. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Excess Payment: Bonus to Exiting Partner Mo Capital 80 Nel Capital 8 Owen Capital 4 Cash 92 By treating the excess payment as a bonus to Owen, Mo and Nel each have their capital accounts reduced by their relative profit sharing ratios of 40:20, for the total amount of the $12,000 bonus amount. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Excess Payment: Goodwill Recorded Owen Capital 80 Goodwill 12 Cash 92 By treating the excess payment as an indication that partnership assets were undervalued, Goodwill is recorded. Note that Mo and Nel’s capital accounts are not revalued. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Excess Payment: Used to Revalue Partnership Capital Goodwill 30 Mo Capital 12 Nel Capital 6 Owen Capital The excess payment is used to determine the implied fair value of the partnership. $12,000 excess / Owen’s 40% share = implied partnership under-valuation of $30,000 Owen Capital 92 Cash The exiting partner is then paid the amount of his capital account. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

6: Limited partnerships Partnerships – Formation, Operations, and Changes in Ownership Interests 6: Limited partnerships Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Limited Partnerships Limited partnerships must have one or more general partners with unlimited liability for partnership debt. There may be any number of limited partners. Excluded from participating in management Limited liability for partnership debt Partnership agreement must be in writing, signed and filed Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall