CHAPTER Partnerships: Ownership Changes and Liquidation Fundamentals of Advanced Accounting 1 st Edition Fischer, Taylor, and Cheng 9 9

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #2 Ownership Changes Dissolution – The change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #3 Ownership Changes (continued) Changes may suggest: –The existing assets of the original partnership should be revalued –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

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #4 Admission of a New Partner Admission of new partner requires approval from existing partners 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 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #5 Contribution Of Assets To An Existing Partnership Gain admission to partnership by contributing assets directly to the partnership If book value of partnership net assets approximates fair value New partner’s contribution should be equal to their %age interest in the new capital 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 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #6 Contribution Of Assets To An Existing Partnership (continued) Value of contribution may be less than that indicated by book value of the original partnership’s net assets Suggests that the partnership may have one of the following: –Unrecognized depreciation or write-downs on recorded net assets of the original partnership –Additional intangible assets being contributed by the incoming partner

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #7 Contribution of Assets to an Existing Partnership Bonus method Goodwill method

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #8 The Bonus Method Total capital of new partnership is: The book value of the previous partnership – Any write-downs in the value of the previous partnership’s net assets +The value of the consideration paid to the partnership by the incoming partner Note:Only net asset write-downs (versus write-ups) are recognized.

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #9 The Bonus Method (continued) 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 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #10 The Bonus Method: Bonus to Old Partners A & B are original partners with a partnership net book value of $75,000 Profit/loss percentages: A = 50%, B = 50% C acquires 20% interest in capital for $27,000 cash Facts

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #11 The Bonus Method: Bonus to Old Partners Continued Value of new partnership suggested by incoming partner: $135,000 ($27,000  20%) Book value of new partnership: $102,000 ($75,000 + $27,000) C’s interest in new partnership: $20,400 (20%  $102,000) Analysis

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #12 Cash27,000 A, Capital3,300 B, Capital3,300 C, Capital20,400 Journal Entry The Bonus Method: Bonus to Old Partners Continued

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #13 The Bonus Method: Bonus To The New Partner A & B are original partners with a partnership net book value of $75,000 Profit/loss percentages: A = 50%, B = 50% C acquires 20% interest in capital for $10,000 cash Facts

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #14 Analysis The Bonus Method: Bonus To New Partner (continued) Book value of new partnership: $85,000 ($30,000 + $45,000 + $10,000) C’s interest in new partnership: $17,000 (20%  $85,000)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #15 Cash 10,000 A, Capital3,500 B, Capital 3,500 C, Capital17,000 Journal Entries The Bonus Method: Bonus To New Partner (continued)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #16 Overvaluation Of Original Partnership Previous example assumed the new partner brought some intangible asset to the partnership That same transaction may indicate that the partnership assets are overvalued.

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #17 The Goodwill Method Total capital of new partnership is: The book value of the previous partnership  Unrecognized appreciation or depreciation on the recorded net assets of the previous partnership + Unrecognized goodwill traceable to the previous partnership + The value of the consideration, both tangible and intangible, received from the new incoming partner

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #18 The Goodwill Method (continued) Both net asset write-downs and write-ups are recorded New partner’s initial capital balance equals the percent interest in the capital of the new partnership Goodwill may be traceable to the original partners and/or the new partner

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #19 Identifying and Measuring Goodwill Traceable to the Previous Partnership 1.Calculate the value of the partnership suggested by the incoming partner (incoming partner’s contribution divided by the percent interest in capital acquired) 2.Adjust the book value of the original partnership for any unrecognized net asset appreciation or depreciation (continued...)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #20 Identifying and Measuring Goodwill Traceable to the Previous Partnership (... continued) 3.Calculate adjusted book value of original partnership plus investment of new partner 4.If #1 above is greater than #3 above, goodwill exists and is traceable to the original partners 5.Goodwill is the difference between the value in #1 above and the value in #3 above

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #21 Goodwill Traceable to the Previous Partnership A and B are original partners with a partnership net book value of $75,000 Recorded net assets have a fair value of $135,000 Profit/loss percentages: A = 50%, B = 50% C acquires 20% interest in capital for $27,000 cash Facts

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #22 Goodwill Traceable to the Previous Partnership (continued) Analysis Value of new partnership suggested by incoming partner: $135,000 ($27,000  20%) $33,000 of unrecognized net asset appreciation and/or goodwill is suggested: ($135,000 – [$75,000 + $27,000])

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #23 Analysis, continued Goodwill Traceable to the Previous Partnership (continued) The $33,000 is all allocated to Goodwill

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #24 Cash27,000 Goodwill33,000 A, Capital16,500 B, Capital16,500 C, Capital27,000 Goodwill Traceable to the Previous Partnership (continued) Journal Entry

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #25 Goodwill Traceable to the Previous Partnership (continued) The new partner’s capital account balance represents a 20% interest in the total capital of the new partnership Original capital$75,000 C’s investment27,000 Goodwill33, ,000 C’s interest x 20% C’s Capital balance$27,000

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #26 Identifying and Measuring Goodwill Traceable to the New Partner 1.Calculate the value of the partnership suggested by the incoming partner (incoming partner’s contribution divided by the percent interest in capital acquired) 2.Adjust the book value of the original partnership for any unrecognized net asset appreciation or depreciation (continued...)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #27 3.Calculate adjusted book value of original partnership plus investment of new partner 4.If #1 above is less than #3 above, then goodwill exists and is traceable to the new partner (continued...) Identifying and Measuring Goodwill Traceable to the New Partner (continued)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #28 5.Goodwill is the difference between: a)The amount that should have been paid by the new partner, as indicated by the adjusted book value of the previous partnership [(adjusted book value of the original partnership  total percentage interest of the original partners in the new partnership) – the adjusted book value] and b)The amount actually paid by the new partner Identifying and Measuring Goodwill Traceable to the New Partner (continued)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #29 Goodwill Traceable to the New Partner Facts A and B are original partners with a partnership net book value of $75,000 The $75,000 capital for A & B makes up 80% of the new capital (after C is admitted) $75,000 / 20% = $93750 Profit/loss percentages: A = 50%, B = 50% C acquires 20% interest in capital for $10,000 cash

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #30 Analysis Value of new partnership suggested by incoming partner: $93,750 ($75,000  80%) New partner should have paid: $18,750 ($93,750 -$75,000) New partner only paid: $10,000 The difference between what the new partner should have paid: $18,750 and what they actually did pay: $10,000 is goodwill traceable to the new partner: $8,750 Goodwill Traceable to the New Partner (continued)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #31 Journal Entry Cash10,000 Goodwill8,750 C, Capital18,750 Goodwill Traceable to the New Partner (continued)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #32 Goodwill Previous examples allocated differences to either revaluation of assets or goodwill –Most often a combination of both Goodwill may be traceable to either the original partners or the incoming partners

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #33 Goodwill Method Vs. Bonus Method Bonus method establishes total capital of new partnership based on actual consideration received from the new partner Goodwill method results in recognition of an asset implied by a transaction rather than recognizing an asset actually purchased Goodwill method could produce inequitable results –If new partner’s interest in profits ≠ initial interest in capital –After formation of new partnership, old partners share profits and losses in different percentages than before

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #34 Contribution of Assets to Existing Partners Generally, a portion of the selling partner’s book value of capital is transferred to the buying partner New partner pays directly to partner selling their share Example: The book value of A’s capital interest is $30,000. C acquires one-half of A’s capital interest for $50,000. A, Capital15,000 C, Capital15,000

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #35 Withdrawal of a Partner Partnership agreement should be consulted to determine any guidelines that would influence the procedure Requires determination of fair value of partnership entity and Measurement of partnership income to date of withdrawal Recognizing differences between book and fair value maybe appropriate Withdrawing partner may sell interest to: –The partnership and/or –An individual partner

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #36 Selling Interest To Existing Partners Equity of withdrawing partner purchased with personal assets of existing partner Not assets of the partnership!

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #37 Selling of an Interest to the Partnership The bonus or goodwill method may be employed The bonus method will only recognize net asset write-downs (versus write-ups)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #38 Selling of an Interest to the Partnership (continued) Goodwill method focuses on the payment to withdrawing partner as indication of fair value of the partnership Two alternatives available –Recognize only goodwill traceable to selling partner –Recognize goodwill traceable to the whole entity

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #39 Partnership Liquidation Partnership liquidation results in partnership ending or terminating its business Underlying them is equitable distribution of assets

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #40 Partnership Liquidation Guidelines The UPA establishes rules governing the priority in which partnership assets are distributed Following sequence of payments should be observed 1.Amounts owed to creditors other than partners 2.Amounts owed to partners other than capital and profits 3.Amounts owed to partners as capital 4.Amounts owed to partners as profits

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #41 Partnership Liquidation Guidelines (continued) The doctrine of “right of offset” combines loans due to partners with the capital balances of partners The liability for debit capital balances is covered by the doctrine of “marshalling of assets” If debit capital balances are not eliminated, they are allocated to the other partners with credit capital balances All attempts should be made to avoid premature liquidation payments to partners

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #42 Marshalling of Assets Doctrine Applies when a partnership or one of more of its partners is insolvent (liabilities exceed assets) 1.Partnership assets are first available for payment of partnership debts 1.Available for partners’ personal debts 2.Only to extent of partner’s interest in capital of the partnership 2.Personal assets of a partner are applied against personal debts, ranked in order of priority 1.Amounts owed to personal creditors 2.Amounts owed to partnership creditors 3.Amounts owed to partners by way of contribution

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #43 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 in installments rather than in a final lump sum –Caution must be exercised to insure that no premature distributions are made

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #44 Installment Liquidation Guidelines The “right of offset” doctrine is employed All liabilities, possible losses, and liquidation expenses are anticipated before payments may be made to partners Prior to a cash distribution, all remaining noncash assets are assumed to be worthless

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #45 Installment Liquidation Guidelines (continued) With respect to potential debit capital balances, all partners are assumed to be personally insolvent Actual distributions are based on a schedule of safe payments or a predistribution plan –Assumes all remaining assets are worthless –Assumes any partner with deficit capital balance is insolvent New schedule of safe payments is calculated before every cash distribution

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #46 Predistribution Plan Based on how much loss a partner could absorb (i.e., maximum loss absorbable, the MLA) MLA = partner’s capital balance  partner’s profit and loss percent Partner with the largest MLA is the strongest and should be the first to receive a distribution

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 9, Slide #47 Predistribution Plan (continued) Actual distributions reduce partners’ capital balances and their respective MLAs When all partners have equal MLAs they will all receive a distribution