Transcript Advanced Accounting by Hoyle et al, 6th Edition

Chapter Fourteen
Partnerships:
Formation and
Operation
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
Partnerships
A partnership is defined as “an
association of two or more persons to
carry on a business as co-owners for
profit.” (Section 6 of Uniform
Partnership Act)
14-3
Economic Importance of
Partnerships

The Internal Revenue Service projects that
by 2012, nearly 3.6 million partnership
income tax returns will be filed in the United
States
(Source: www.irs.gov)

Rationale:
 Reducing expenses, increasing expertise and
expanding services
 Tax benefits
 Easily created by families and friends
 Required by some professions (although these
restrictions are fast disappearing)
14-4
Partnership Advantages

Flexibility in defining relationships
 Ownership interest and profit distribution may not
be dependent on investment
 Losses may be allocated differently than profits


Ease of formation and dissolution
Easier to implement a desired control format
 Not based on ownership percentage of voting
shares as with corporations

Taxed on a “flow-through” (conduit) basis
 The partnership itself does not pay income taxes
 Income, deductions and tax credits are “passed
through” to the partners, based on their respective
percentage interests. The partners report these on
their individual returns
14-5
Partnership Disadvantages

Unlimited liability incurred by each
partner (they are “jointly and
severally” liable)
 Mutual agency (each partner has the
right to incur liabilities in the name of
the partnership)
 Inability to participate in various
corporate tax benefits
14-6
Partnerships Capital Accounts



The equity section of a
partnership consists of
capital balances for each
partner.
Profits/losses for each
period are allocated to
each partner’s capital
account.
Withdrawals by partners
reduce their capital
accounts.
14-7
Alternative Legal Forms Subchapter S Corporation
Often referred to
as an S-Corp
. . . Has all the legal
characteristics of a
corporation.
. . . Profit passes to owners
just as with a partnership.
. . . Ownership is limited to 75
stockholders.
Owners limited to individuals,
estates, and certain taxexempt entities and trusts
14-8
Alternative Legal Forms Limited Partnership
Tax benefits of a
partnership
without unlimited
liability.
. . . A number of “limited”
partners who are not allowed
to participate in management.
. . . Losses are restricted to
amount invested.
. . . Must have one or more
general partners who assume
responsibility for all
obligations.
14-9
Alternative Legal Forms –
Limited Liability Partnerships
. . . Most of the
characteristics of a general
partnership.
EXCEPT
. . . Partners are liable only
for their own acts and
omissions, and the acts
and omissions of those
under their direct
supervision.
LLP laws
differ from
state to state.
14-10
Alternative Legal Forms –
Limited Liability Companies
. . . Classified as a
partnership for tax
purposes.
. . . Owners only risk their
own investments.
. . . The number of owners
is not usually restricted.
LLC laws
differ from
state to state.
14-11
Articles of Partnership



Partnerships can exist
even in the absence of a
written partnership
agreement.
The Uniform Partnership
Act establishes
standards and rules for
partnerships.
A written agreement will
supersede the UPA
standards.
14-12
Articles of Partnership
Method for
dispute
settlements
Method for
settling a
partner’s share
upon
withdrawal,
retirement or
death
Profit/loss
sharing
percentages
Put it in
writing!!!
Rights and
responsibilities
of partners
Method for
admitting
new partners
Initial
contribution to
be made by
each partner
14-13
Articles of Partnership
Business
Location
Withdrawal
limits
Method for
valuing
individual
contributions
Name and
Address of
Each Partner
Put it in
writing!!!
Description of
the Nature of
the Business
Life insurance
provisions
enabling
survivor
acquisition of
decedent
interest
14-14
Accounting for Capital
Contributions
If the partners each contribute cash . . .
 . . . debit Cash.
 . . . credit individual Partner Capital
accounts.
Partnership Journal
Date
Description
Cash
Page
Debit
##
Credit
$$$
Capital - Partner A
Capital - Partner B
$$$
$$$
14-15
Accounting for Capital
Contributions
If the partners each contribute cash and other
assets . . .
 . . . debit Cash & Contributed Assets for FV.
 . . . credit individual Partner Capital
accounts.
Partnership Journal
Date
Description
Cash
Contributed Assets (FV)
Capital - Partner A
Capital - Partner B
Page
Debit
##
Credit
$$$
$$$
$$$
$$$
14-16
Accounting for Capital
Contributions

Intangible assets, such as expertise, require
special consideration
 Use either the Bonus Method or the Goodwill
Method.

Record the tangible assets
contributed.
 Adjust the partner capital
balances to reflect the
relative value of the
intangible asset.
Intangible Contributions Bonus Method
14-17
On 2/15/08, Cookie and Bijou form a partnership.
They agree to equal capital balances. Cookie
contributes $80,000 cash. Bijou contributes
land valued at $40,000.
Partnership Journal
Date
Description
Page
Debit
Prepare the journal entry to set
up the partnership.
##
Credit
14-18
Intangible Contributions –
Bonus Method
Total tangible assets for the partnership are $120,000.
The partners have agreed to have equal capital
balances, based on the contributed assets, even
though Bijou only contributed land worth $40,000.
Essentially, Cookie has given Bijou a $20,000 bonus.
Partnership Journal
Date
Description
15-Feb Cash
Land
Page
Debit
##
Credit
80,000
40,000
Capital - Cookie
Capital - Bijou
60,000
60,000
14-19
Intangible Contributions Goodwill Method


Record the tangible
assets contributed.
Record the
contributed intangible
asset as the difference
between the
contributed tangible
assets and the implied
value of the
partnership.
Intangible Contributions Goodwill Method
14-20
On 2/15/08, Cookie and Bijou form a partnership. They
agree to equal capital balances. Cookie contributes
$80,000 cash. Bijou contributes land valued at
$40,000, and brings years of experience to the new
business.
Partnership Journal
Date
Description
Page
Debit
Prepare the journal entry to set
up the partnership.
##
Credit
14-21
Intangible Contributions Goodwill Method
On 2/15/08, Cookie and Bijou form a partnership. They
agree to equal capital balances. Cookie contributes
$80,000 cash. Bijou contributes land valued at
$40,000, and brings years of experience to the new
business.
Cookie's Tangible Contributed Assets
Cookie's Capital %
Implied Value of the Partnership
$
80,000
÷
50%
$ 160,000
Implied Value of the Partnership
Total Tangible Contributed Assets
Goodwill Attributed to Bijou
$ 160,000
120,000
$ 40,000
Intangible Contributions Goodwill Method
14-22
Cookie’s capital account is credited for the tangible
contribution of $80,000.
Bijou’s capital account is credited for the tangible
contribution of $40,000, plus the intangible
contribution valued at $40,000.
Partnership Journal
Date
Description
15-Feb Cash
Land
Goodwill
Capital - Cookie
Capital - Bijou
Page
Debit
##
Credit
80,000
40,000
40,000
80,000
80,000
14-23
Allocation of Income

The allocation of income is
not necessarily based on
the relative capital
balances.
 It is a separately negotiated
item.

Items to be allocated:
Remaining
income
Interest on
beginning
capital balances
Allocated
compensation
Bonuses
14-24
Allocation of Income
Example
Mushon and Gee, a retail partnership
selling pet products, has beginning of
period capital balances of $50,000 and
$70,000 respectively. Net income for the
period is $100,000.
Both partners are credited with 10%
interest on their beginning capital
balance. In addition, Mushon is credited
with a bonus of $20,000 per the
partnership agreement. They share
income 40:60 (Mushon:Gee).
What are the ending capital balances for
each partner?
14-25
Allocation of Income
Example
Mushon
Interest on capital
balances
Bonus to Mushon
Allocation of
remaining income
Total
Gee
Total
14-26
Allocation of Income
Example
Mushon
Interest on capital
balances
Bonus to Mushon
Allocation of
remaining income
Total
5,000
Gee
7,000
Total
12,000
14-27
Allocation of Income
Example
Mushon
Interest on capital
balances
Bonus to Mushon
Allocation of
remaining income
Total
5,000
20,000
Gee
7,000
Total
12,000
20,000
14-28
Allocation of Income
Example
Mushon
Interest on capital
balances
Bonus to Mushon
Allocation of
remaining income
Total
5,000
20,000
27,200
52,200 $
$
Gee
7,000
Total
12,000
20,000
40,800
68,000
47,800 $ 100,000
(
100,000
-
12,000
-
20,000
) × 40% = $ 27,200
(
100,000
-
12,000
-
20,000
) × 60% = $ 40,800
14-29
Legal Dissolution

Any alteration in the specific individuals
composing a partnership automatically leads
to “legal dissolution”
 Departures
 Retirement
 Death
 Admission of a New Partner
• Promotions
• Buy-ins


Frequently this leads to the immediate
formation of a new partnership as the
business continues
Can lead to termination and liquidation
Admission of a New Partner The Rights of a Partner
14-30
An individual partner’s
ownership rights
include:



The right to co-ownership
in the business property.
The right to share in
profits and losses as
specified in the
partnership agreement
The right to participate in
the management of the
business.
These two rights
can be sold (unless
restricted by the
articles of
partnership)
This right
cannot be sold
without the
other partners’
approval.
14-31
Partnership Dissolution Admission of a New Partner

When the makeup of the partnership
changes, the partnership is dissolved.
 A new partnership is immediately
formed.
 New partner acquires partnership
interest by:
 Purchasing it from the other partners, or
 Making a contribution to the partnership.
14-32
Admission of a New Partner Purchase of a Current Interest

A new partner can
purchase partnership
interest directly from the
existing partners.
 The cash goes to the
partners, not to the
partnership.

Two methods are available
to account for the transfer
of ownership:
 Book Value Approach
 Goodwill (Revaluation)
Approach
14-33
Admission of a New Partner Purchase of a Current Interest

Book Value Example
Mare, Mic and Roma have a partnership.
Partner Capital Balance
Mare
$
30,000
Mic
$
50,000
$
60,000
Roma

Profit & Loss Ratio
40%
25%
35%
Using the Book Value Approach, prepare the
entry assuming Nia pays $60,000 directly to
the other partners for a 20% partnership
interest.
Admission of a New Partner Purchase of a Current Interest
14-34
Book Value Example

The cash goes to Mare,
Mic and Roma, NOT to
the partnership.
 Each partner gives up
20% of their existing
capital.
Partnership General Journal
Date
Description
Page
Debit
Prepare the journal entry to
admit Nia to the partnership.
18
Credit
Admission of a New Partner
Purchase of a Current Interest
14-35
Book Value Example

The cash goes to Mare,
Mic and Roma, NOT to
the partnership.
 Each partner gives up
20% of their existing
capital.
$30,000 x
$50,000 x
$60,000 x
Partnership General Journal
Date
Description
31-Dec Partner Capital - Mare
Partner Capital - Mic
Partner Capital - Roma
Partner Capital - Nia
20%
20%
20%
=
=
=
Page
Debit
$6,000
$10,000
$12,000
18
Credit
6,000
10,000
12,000
28,000
14-36
Admission of a New Partner Purchase of a Current Interest

Goodwill (Revaluation) Example
Mare, Mic and Roma have a partnership.
Partner Capital Balance
Mare
$
30,000
Mic
$
50,000
$
60,000
Roma

Profit & Loss Ratio
40%
25%
35%
Using the Goodwill Approach, prepare the
entry assuming Nia pays $60,000 directly to
the other partners for a 20% partnership
interest.
14-37
Admission of a New Partner Purchase of a Current Interest
Goodwill (Revaluation) Example

The implied value of the partnership is $300,000
 $60,000 ÷ 20% = $300,000
 First, compute the Goodwill
Implied Value of the Partnership
Current Book Value of the Net Assets*
Implied Goodwill to be Allocated
$ 300,000
140,000
$ 160,000
* Current book value is inferred from the combined
capital balances of the existing partners.
Admission of a New Partner Purchase of a Current Interest
14-38
Goodwill (Revaluation) Example
Allocate the $160,000 of Goodwill to the
existing partners, based on their income
sharing %. (40:25:35)
Partnership General Journal
Date
Description
Page
Debit
Prepare the journal entry to
allocate goodwill to Mare, Mic
and Roma.
18
Credit
Admission of a New Partner Purchase of a Current Interest
14-39
Goodwill (Revaluation) Example
Allocate the $160,000 of Goodwill to the
existing partners, based on their income
sharing %. (40:25:35)
Partnership General Journal
Date
Description
Goodwill
Partner Capital - Mare
Partner Capital - Mic
Partner Capital - Roma
Page
Debit
18
Credit
160,000
64,000
40,000
56,000
14-40
Admission of a New Partner Purchase of a Current Interest
Goodwill (Revaluation) Example
The new balances for Mare, Mic and Roma appear
as follows:
Mare Capital
30,000
64,000
94,000
Mic Capital
50,000
40,000
90,000
Roma Capital
60,000
56,000
116,000
Next, allocate 20% from each of the existing
partners to Nia.
Admission of a New Partner Purchase of a Current Interest
14-41
Revaluation Example
Note that Nia’s balance,
after allocation from
the current partners,
equals Nia’s
contribution of
$60,000.
$94,000 x
$90,000 x
$116,000 x
Partnership General Journal
Date
Description
31-Dec Partner Capital - Mare
Partner Capital - Mic
Partner Capital - Roma
Partner Capital - Nia
20%
20%
20%
=
=
=
Page
Debit
$18,800
$18,000
$23,200
18
Credit
18,800
18,000
23,200
60,000
14-42
Admission of a New Partner Contribution to the Partnership



The new partner can gain
partnership interest by
contributing cash to the
partnership.
Remember that the new
cash will increase the
partnership’s net assets.
Two methods are:
 Bonus Approach
 Goodwill Approach
14-43
Admission of a New Partner Contribution to the Partnership

Bonus Example
Mare, Mic and Roma have a partnership.
Partner Capital Balance
Mare
$
30,000
Mic
$
50,000
$
60,000
Roma

Profit & Loss Ratio
40%
25%
35%
Using the Bonus Approach, prepare the
entry assuming Nia pays $60,000 to the
partnership for a 20% partnership interest.
14-44
Admission of a New Partner Contribution to the Partnership
Bonus Example



Net assets after the contribution are $200,000.
Nia gets credit for 20% of net assets ($200,000 x 20%).
The remainder of the $60,000 contribution is allocated
to the other partners.
Note that the $200,000
results from the net assets of
the partnership of $140,000 +
Nia’s $60,000 contribution.
Prepare the journal
entry.
Admission of a New Partner Contribution to the Partnership
14-45
Bonus Example



Net assets after the contribution are $200,000.
Nia gets credit for 20% of net assets ($200,000 x 20%).
The remainder of the $60,000 contribution is allocated
to the other partners.
Date
Description
NoteCash
that the $200,000
results from
the net
assets
Partner
Capital
- Niaof
the partnership
$140,000
+
Partnerof
Capital
- Mare
Partnercontribution.
Capital - Mic
Flatt’s $60,000
Partner Capital - Roma
Debit
Credit
60,000
40,000
8,000
Prepare the journal
5,000
entry. 7,000
14-46
Admission of a New Partner Contribution to the Partnership
Goodwill Example
 Mare, Mic and Roma have a
partnership.
Partner Capital Balance
Mare
$
30,000
Mic
$
50,000
$
60,000
Roma

Profit & Loss Ratio
40%
25%
35%
Using the Goodwill Approach, prepare
the entry assuming Nia pays $60,000 to
the partnership for a 20% partnership
interest.
Admission of a New Partner Contribution to the Partnership
14-47
Goodwill Example


Net assets after the contribution are $200,000.
Implied value of the partnership is $300,000.
 $60,000 ÷ 20% = $300,000

Goodwill to be recorded is $100,000 (300,000 - 200,000)
Date
Description
Debit
Prepare the journal entry to
allocate goodwill to Mare, Mic
and Roma.
Credit
Admission of a New Partner Contribution to the Partnership
14-48
Goodwill Example


Net assets after the contribution are $200,000.
Implied value of the partnership is $300,000.
 $60,000 ÷ 20% = $300,000

Goodwill to be recorded is $100,000 (300,000 - 200,000)
Date
Description
Goodwill
Partner Capital - Mare
Partner Capital - Mic
Partner Capital - Roma
Debit
Credit
100,000
40,000
25,000
35,000
Admission of a New Partner Contribution to the Partnership
14-49
Goodwill Example
After allocating the goodwill to the original
partners, record Nia’s cash contribution and
credit Nia’s capital account.
Date
Description
Debit
Prepare the journal entry to
admit Nia to the partnership.
Credit
Admission of a New Partner Contribution to the Partnership
14-50
Goodwill Example
After allocating the goodwill to the original
partners, record Nia’s cash contribution and
credit Nia’s capital account.
Date
Description
Cash
Partner Capital - Nia
Debit
Credit
60,000
Prepare the journal entry to
admit Flatt to the partnership.
60,000
14-51
Summary
A partnership is defined as “an
association of two or more persons to
carry on a business as co-owners for
profit.”
 This form of business organization is
popular for many reasons, primarily
ease of formation and organization
 There are tax benefits as a result of
their flow-through nature
 Disadvantages include unlimited
liability and mutual agency

14-52
Possible Criticisms

Because corporations can be considered
“persons” for purpose of partnership
formation, some critics contend that this
form of business organization can be easily
manipulated for fraudulent intent.

Others argue that unlimited liability and
mutual agency provisions are too strict and
unduly limit commerce.
WHAT DO YOU THINK????