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Chapter 16
Partnerships – Formation, Operations, and Changes in Ownership Interests
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2. 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.
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3. 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.
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4. 1: partnership characteristics
Partnerships – Formation, Operations, and Changes in Ownership Interests
1: partnership characteristics
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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
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6. 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
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7. 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
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Partnerships – Formation, Operations, and Changes in Ownership Interests
2: initial investment
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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
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10. 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
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11. 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: ( ) / 2 = $46 each
Cash 7
Inventory 35
Land 10
Building 40
Amy Capital 46
Paul Capital
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12. 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: ( ) / 50% = $100
Paul's: (7 + 35) / 50% = $84
Use Amy’s investment to determine implied value of firm -- $100.
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13. Initial Entry with Goodwill
Paul's 50%($100) $50
He invests:
Cash $7
Inventory $ $42
Goodwill $8
Amy's 50%($100) $50
She invests:
Land $10
Building $ $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
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14. 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.
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15. 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.
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16. Statement of Partners' Capital
Beginning capital + investments – drawings and/or withdrawals + income or – loss = ending capital
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17. 3: profit and loss sharing agreements
Partnerships – Formation, Operations, and Changes in Ownership Interests
3: profit and loss sharing agreements
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18. 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
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19. 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.
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20. 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
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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.
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22. 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.
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23. 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%( ) = 80
Lot Interest = 10%(400) = 40
Babel Interest = 10%(350) = 35
Allocation: 60%(415) = 249; 40%(415) = 166
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24. 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
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25. 4: admitting a new partner
Partnerships – Formation, Operations, and Changes in Ownership Interests
4: admitting a new partner
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26. 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.
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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.
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28. 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
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29. 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, $ 90
Goodwill 30
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30. 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.
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31. 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
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32. 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
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33. 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, $
$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.
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34. 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.
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35. 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, $
$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.
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36. 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.
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37. 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
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38. 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
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39. 5: Death or retirement of a partner
Partnerships – Formation, Operations, and Changes in Ownership Interests
5: Death or retirement of a partner
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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
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41. 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.
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42. 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.
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43. 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.
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44. 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.
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45. 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.
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46. 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.
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47. 6: Limited partnerships
Partnerships – Formation, Operations, and Changes in Ownership Interests
6: Limited partnerships
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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
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