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Chapter 15: Partnerships – Formation, Operations, and
Changes in Ownership Interestsby Jeanne M. David, Ph.D., Univ. of Detroit Mercy
to accompany
Advanced Accounting, 10th editionby Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn
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Partnerships: Objectives
1. Comprehend the legal characteristics of partnerships.
2. Understand initial investment valuation and record keeping.
3. Grasp the diverse nature of profit and loss sharing agreements and their computation.
4. Value a new partner's investment in an existing partnership.
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Objectives (cont.)
5. Value a partner's share upon retirement or death.
6. Understand limited liability partnership characteristics.
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1: Characteristics of Partnerships1: Characteristics of Partnerships
Partnerships – Formation, Operations, and Changes in Ownership Interests
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Partnerships
RUPA "Revised Uniform Partnership Act"– Entity theory:
• partners own their share of the partnership, but not its individual assets
– Dissociation: • partners can dissociate without dissolution
Partners have – Mutual agency– Unlimited liability
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Articles of Partnership
1. Products or services, line of business2. Partner rights & responsibilities3. Initial investment and value assigned to
noncash investments4. Additional investment conditions5. Asset withdrawals6. Profit and loss sharing7. Dissolution procedures
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Partnership Reporting
• Financial reporting should provide for the needs of– Partners– Creditors of the partnership– IRS
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2: Initial Investment2: Initial Investment
Partnerships – Formation, Operations, and Changes in Ownership Interests
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Initial Investment
A partnership is started by Amy and Paul, each investing cash.
If they invest other assets, the value of those assets should be agreed upon in advance.
Cash XXX Amy Capital XXX
Cash XXX Paul Capital XXX
Cash XXX Equipment XXX
Land XXX Paul Capital XXX
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Initial Investment with Bonus or GoodwillPartner initial investments, at fair value, will not
represent their ownership.– Individual talent– Business connections– Customer base
Partners choose method– Bonus method
• Adjustment within the capital accounts– Goodwill method
• Goodwill is recorded on the books
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Initial Investment with BonusTotal fair value received is split, as desired,
between partnersCola invests land and building worth $10 and $40.Crown invests cash and inventory at $7 and $35.Agree to have equal shares:
(10 + 40 + 7 + 35) / 2 = $46 eachCash 7 Inventory 35
Land 10 Building 40
Cola Capital 46
Crown Capital 46
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Initial Investment with Goodwill
Cola's 50%(100) $50He invests: Land $10 Building $40
$50
Crown's 50%(100) $50He invests: Cash $7 Inventory $35 $42Goodwill $8
If Cola and Crown agree to equal shares, use larger implied total value of firm.
Cola's: (10 + 40) / 50% = $100Crown's: (7 + 35) / 50% = $84
Implied value of firm $100
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Initial Entry with Goodwill
Land 10 Building 40
Cola Capital 50
To record Cola's investment
Cash 7
Inventory 35
Goodwill 8
Crown Capital 50
To record Crown's investment and goodwill
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Partner Accounts
Each partner has his/her own accounts for– Capital– Drawings (periodic, salary-like, amounts)– Withdrawals (other, large, unusual amounts)
• Investments increase Capital• Drawings and withdrawals are closed to Capital• Income Summary or Revenue and Expense
Summary is closed to Capital.
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Sample Partner Closing EntriesAmy Capital XXX
Amy Drawings XX
Amy Withdrawals XX
Reduces Amy's capital for drawings and withdrawalsPaul Capital XXX
Paul Drawings XXX
Income Summary Profit
Amy Capital XXX
Paul Capital XXX
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 while other have profits.
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Statement of Partners' Capital
Beginning capital + investments – drawings and/or withdrawals + income or – loss = ending capital
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3: Sharing Profit and Loss3: Sharing Profit and Loss
Partnerships – Formation, Operations, and Changes in Ownership Interests
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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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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
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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
Partner's allowances for bonus, salary and interest are allocated to them, whether or not sufficient profits exist.
Remaining profits (or deficit) is then split according to the agreed-upon proportions.
These are general procedures. The partnership articles provide the specific requirements.
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Example: Sharing Profits
Tom and Betty agree to share profits and losses:• Tom and Betty have $60 and $30 salary allowances• Betty has a bonus of 50% of profits in excess of $500• Each have interest allowances of 10% of beginning
capital– Tom Capital, 1/1 $400– Betty Capital, 1/1 $350
• Remaining profits or losses are shared Tom 60%, Betty 40%.
Partnership profits are $660 for the year.
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Share Profits of $660
Bonus = 50%(660 - 500) = 80Tom Interest = 10%(400) = 40Betty Interest = 10%(350) = 3560%(415) = 249; 40%(415) = 166
Total Tom BettyNet income $660 Salary allowance (90) $60 $30 Bonus allowance (80) 0 80 Interest allowance (75) 40 35 Subtotal $415 Split 60:40 (415) 249 166 Allocated net income $0 $349 $311
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Share Profits of $180Assume instead that income was only $180.
Bonus = zero, income does not exceed thresholdTom Interest = 10%(400) = 40Betty Interest = 10%(350) = 3560%(-45) = -27; 40%(-45) = -18
Total Tom BettyNet income $120 Salary allowance (90) $60 $30 Bonus allowance 0 0 0 Interest allowance (75) 40 35 Subtotal, deficit ($45) Split 60:40 45 (27) (18)Allocated net income $0 $73 $47
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4: Admitting a New Partner4: Admitting a New Partner
Partnerships – Formation, Operations, and Changes in Ownership Interests
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Admitting a New Partner
1. A current partner assigns interest to new partner.
2. New partner purchases interest from existing partner.• Goodwill method• Bonus method
3. New partner invests directly in partnership.• Goodwill method• Bonus method
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Assignment
Assignment gives the assignee 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 XXX
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Buy from Partner: Simple
Alfano and Bailey have capital balances of $50 each and each have a 50% interest in the firm.
Cobb buys half of Alfano's interest for $25.
Before After
Capital Share Capital Share
Alfano $50 50% $25 25%Bailey 50 50% 50 50%Cobb 25 25%Total $100 $100
Alfano Capital 25
Cobb Capital 25
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Buy from Partner: Goodwill
Don and Ed have capital of $50 and $40 with each 50% interest.
Fay will pay $60 directly to the partners and receive 50% interest in the firm. Don and Ed each keep 25%. Assets are at fair value.
The goodwill increases Don & Ed's capital each by $15.
Implied value of firm, $60/.50 120 Old capital, $50 + 40 90 Goodwill 30
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Goodwill Revalues Capital
Presumably, Fay paid $35 to Don and $25 to Ed.If the partners had not wanted to realign the
capital, the capital of Don and Ed would each be reduced by $30 to transfer the $60 to Fay.
Before RevaluationAfter
revaluation Transfer FinalDon $50 $15 $65 ($35) $30 Ed 40 15 55 (25) 30 Fay 60 60
Total $90 $120 $120
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Buy from Partner: Bonus
If Don and Ed had decided not to revalue the assets or record goodwill, the bonus method is used.
Fay's capital is 50%(90) = $45.Don and Ed Capital accounts are adjusted to their
new balances 25%(90) = $22.5
Before Transfer FinalDon $50 ($27.5) $22.5 Ed 40 (17.5) 22.5 Fay 45.0 45.0
Total $90 $90.0
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Entries for Purchase from PartnerEntries for Fay's admission, under goodwill and
bonus methods:Goodwill 30
Don Capital 15
Ed Capital 15
Don Capital 35
Ed Capital 25
Fay Capital 60Goodwill method, aligning capital accountsDon Capital 27.5
Ed Capital 17.5
Fay Capital 45Bonus method, aligning capital accounts
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Invest in Business: GoodwillAndrew and Boyles have capital balances of $40
and $40 and share equally in the firm.Criner will be admitted with an investment of $50
cash. All three will have equal shares. 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 Criner: $130*1/3 = $43.3, but he pays $50 … so goodwill goes to old partners.Implied firm value is based on Criner's investment.
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Investment and Goodwill Add to Capital (Goodwill to Old Partners)
Capital of $80 at the start, increases by the $20 goodwill and the $50 cash investment.
BeforeRevalu-ation
After re-valuation Investment Final
Andrew $40 $10 $50 $50 Boyles 40 10 50 50 Criner $50 50
Total $80 $100 $150
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Invest in Business: GoodwillAndrew and Boyles have capital balances of $40
and $40 and share equally in the firm.Criner will be admitted with an investment of $50
cash. Criner will be given a 40% share; Andrew and Boyles will each have 30%. Net assets are at fair value; goodwill will be recorded.
Implied value of firm, $80/(.60) $133.3Old capital, $40 + 40 $80 Additional investment 50 130.0 Goodwill $3.3 Criner: $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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Investment and Goodwill Add to Capital (Goodwill to New Partner)
Capital of $80 at the start, increases by the $3.3 goodwill and the $50 cash investment.
BeforeRevalu-ation
After re-valuation Investment Final
Andrew $40 $40 $40.0
Boyles 40 40 40.0 Criner $3.3 3.3 $50 53.3
Total $80 $83.3 $133.3
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Invest in Business: Bonus
Andrew and Boyles decide not to revalue the business assets, and Criner invests $50 cash in the business for a 1/3 interest.
Criner's new capital = 1/3 of the total $130. Since he invests on $50 cash for a $52 interest, the $2 bonus is transferred from the old partners.
Before Investment Bonus Final
Andrew $50 ($1) $49
Boyles 40 (1) 39Criner $50 2 52
Total $90 $130
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Entries for Investment in BusinessEntries for Criner's investment, under goodwill
and bonus methods:Goodwill 20
Andrew Capital 10
Boyles Capital 10
Cash 60
Criner Capital 60Goodwill method, goodwill to old partnersCash 50
Andrew Capital 1
Boyles Capital 1
Criner Capital 52
Bonus method, bonus to new partner
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5: Death or Retirement of a Partner5: Death or Retirement of a Partner
Partnerships – Formation, Operations, and Changes in Ownership Interests
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DissociationFirm value, according to RUPA, is the greater of
– Liquidation value– Sales value as a going concern without the dissociated
partnerPayment to exiting partner is
– 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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6: Limited Liability Partnership6: Limited Liability Partnership
Partnerships – Formation, Operations, and Changes in Ownership Interests
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Limited Partnerships
Limited partnerships must have one or more general partners
Limited partner– Excluded from participating in management– Limited liability– Partnership agreement
• In writing, signed and filed
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