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Partnerships: Formation, Operation,

and Changes in Membership

ARTHIK DAVIANTI

Understand and explain the nature and regulation

of partnerships.

What is a Partnership?

An association of two or more persons who

• are co-owners of a business, and

• share profits and losses in an agreed-upon manner. ABC

Company

A B

What is a “Person”?

•An individual•A corporation•Another partnership

Z Corp T&DPartnership

Partnerships: Pros & ConsAdvantages:

• Ease of formation• Lack of formality• Single taxation

Disadvantages:• Unlimited liability (for general partnerships)• Difficulty in disposing of partnership interests• Mutual agency

The Partnership Agreement•What is a partnership agreement?

A written expression of what the partners have agreed to. • Examples of areas addressed:• Manner of sharing profits.• Limitations on withdrawals.• Rights of partners.• Settling with withdrawing partners.• Expulsion of partners.• Conflicts of interest.

Make calculations and journal entries for the

formation of partnerships.

Partners’ Accounts

• Each partner can have• a capital account.• a drawing account (a contra capital

account—closed out at year-end).• a loan account (loans usually earn interest

—a partnership expense).• Partnerships do NOT use a retained

earnings account.DR CR

Initial Investment in a Partnership

Initial investment in a partnership are recorded in capital accounts maintained for each partner.If Ash and Bec each invest $20,000 cash in a new partnership, the accounting records:

Cash (+A) 20,000Ash capital (+OE)

20,000

To record Ash’s original investment of cashCash (+A) 20,000

Bec capital (+OE)20,000

To record Bec’s original investment of cash

Noncash InvestmentsThe noncash property is recorded at the fair value of the property at the time of the investment.Example, Col and Cro enter into a partnership with the following investment:

Col(Fair Value)

Cro(Fair Value)

Cash - 7,000Land (cost to Coll, $5,000) 10,000 -Building (cost to Col, $30,000) 40,000 -Inventory item (cost to Cro, $28,000) - 35,000 Total 50,000 42,000

Noncash InvestmentsRecord of the investments:

Land (+A) 10,000Building (+A) 40,000

Col capital (+OE)50,000

To record Col’s original investment of land and building at fair valueCash (+A) 7,000Inventory (+A) 35,000

Cro capital (+OE)42,000

To record Cro’s original investment of cash and inventory items at fair value

Bonus or Goodwill in Initial Investments

• The partnership agreement specifies equal capital interest – account balances of Col and Cro to meet the agreement’s conditions.• Under the bonus approach, the unidentifiable asset

is not recorded on the partnership books.


The total identifiable contributed capital is $92,000, each partner will start with $46,000 if the unidentifiable assets is not recorded.Bonus approach:

Col capital (-OE) 4,000Cro capital (+OE)

4,000

To establish equal capital interests of $46,000 by recording a $4,000 from Col to Cro


Goodwill approach:The unidentifiable asset contributed by Cro – measured on the basis of Col’s $50,000 investment (50%).Total partnership capital of $100,000 ($50,000 : 50%)Goodwill of $8,000 ($100,000 total capital - $92,000 identifiable assets)Record:

Goodwill (+A) 8,000Cro capital (+OE)

8,000

To establish equal capital interests of $50,000 by recognizing Cro’s investment of an $8,000 unidentifiable asset.

Additional Investments and Withdrawals

Additional investments are credited to the investing partner’s capital account at fair value.Withdrawals are recorded directly in the withdrawing partner’s capital account.Such a withdrawal is:

Smith capital (-OE) 20,000Cash (-A)

20,000

To record the withdrawal of cash

DrawingsWithdrawals – drawings, drawing allowances, or sometimes salary allowances.Example, if Tow and Lee withdraw $1,000 from the partnership each month, the records:

Tom drawing (-OE) 1,000Cash (-A)

1,000

To record Tow’s drawing allowance for JanuaryLee drawing (-OE) 1,000

Cash (-A)1,000

To record Lee’s drawing allowance for January

DrawingsIf Tow draws $1,000 each month during the year, at year-end the balance is $12,000.His drawing account is closed:

Tom capital (-OE) 12,000Tow drawing (+OE)

12,000

To record Tow’s drawing allowance for January

Partnership OperationsPartnership general-purpose financial statement: an income statement, a balance sheet, a statement of partnership capital, and a statement of cash flows.Assume: Rat & Yan are partner sharing profits in a 60:40 ratio. Relevant data for 2011:

Partnership net income 2011 $34,500Rat capital January 1, 2011 40,000Rat additional investment 2011 5,000Rat drawing 2011 6,000Yan capital January 1, 2011 35,000Yan drawing 2011 9,000Yan withdrawal 2011 3,000

Partnership OperationsFormat for a Statement of Partners’ Capital

Rat and Yan Statement of Partners’ Capital For the Year Ended December 31, 2011

60% Rat 40% Yan TotalCapital balances January 1, 2011 40,000 35,000 75,000Add: Additional investment 5,000 - 5,000Deduct: Withdrawals - (3,000) (3,000)Deduct: Drawings (6,000) (9,000) (15,000) Net contributed capital 39,000 23,000 62,000Add: Net income for 2011 20,700 13,800 34,500

Capital balances December 31, 2011 59,700 36,800 96,500

DrawingsClosing entries for the Rat and Yan partnership at December 31, 2011:

December 31, 2011Revenue and expense summary (-OE) 34,500

Rat capital (+OE)20,700

Yan capital (+OE)13,800

To divide net income 60% to Rat and 40% to YanDecember 31, 2011Rat capital (-OE) 6,000Yan capital (-OE) 9,000

Rat drawing (+OE)6,000

Yan drawing (+OE)9,000

To close partner drawing accounts to capital accounts

Profit and Loss Sharing• Equal division – no profit and loss agreement• Agreement on a specified ratio, such as 60:40• Capital as factor for profit sharing• A partner who devotes time – a salary allowanceIllustration:Ann, Gary, and Kate partnership – Ann is the managing partner, Gary is the sales manager, and Kate works outside the partnership.Ann and Gary receive salary allowances of $12,000 each. The remaining income allocated equally.Partnership income is $60,000 for 2011 and $12,000 for 2012.

Profit and Loss SharingINCOME ALLOCATION SCHEDULE - 2011

Ann Gary Kate TotalNet income 60,000Salary allowance to Ann and Gary (24,000) 12,000 12,000 24,000Remainder to be divide 36,000Divided equally (36,000) 12,000 12,000 12,000 36,000Remander to devide 0 Net income allocation 24,000 24,000 12,000 60,000

INCOME ALLOCATION SCHEDULE - 2011Ann Gary Kate Total

Net income 12,000Salary allowance to Ann and Gary (24,000) 12,000 12,000 24,000Remainder to be divide (12,000)Divided equally 12,000 (4,000) (4,000) (4,000) (12,000)Remainder to devide 0 Net income allocation 8,000 8,000 (4,000) 12,000

Profit and Loss SharingEntries to distribute partnership income:December 31, 2011Revenue and expense summary (-OE) 60,000

Ann capital (+OE)24,000

Gary capital (+OE)24,000

Kate capital (+OE)12,000

Partnership income allocation for 2011

December 31, 2012Revenue and expense summary (-OE) 12,000Kate capital (-OE) 4,000

Ann capital (+OE)8,000

Gary capital (+OE)8,000

Partnership income allocation for 2011

Value a new partner’s investment in an existing

partnership.

Purchase of an Interest from Existing Partners

Alf and Bal are partners with capital balances of $50,000 each, they share profit and loss equally.Cob purchases one-half of Alf’s interest from Alf for $25,000, the partnership becomes Alf, Bal, and Cob.Alf and Cob each have a 25 percent interest in the capital and profit. Bal has 50 percent. Entry:

Alf capital (-OE) 25,000Cob capital (+OE)

25,000

To record Cob’s admission into the partnership with the purchase of one-half of Alf’s interest


• Capital and income interests are aligned before and after the admission of Cob.• The net assets of the old partnership were correctly

valued on the books, so no basis for revaluation.• Cob’s payment – 25% in the capital and future income.


• Alf and Ball have capital balances of $50,000 and $40,000 – they share profit equally.• Agree to take Cob with payment of $25,000 directly to

Alf.• The partners may agree – half of Alf’s capital balance

is transferred to Cob.• Net assets are not to be revalued and profit share will

be Alf 25%, Bal 50%, and Cob 25%.• The capital and income interest were not aligned.


Capital Investment

Income Interest

Capital Investment

Income Interest

Alf 50000 5/9 50% 25000 5/18 25%Bal 40000 4/9 50% 40000 8/18 50%Cob 25000 5/18 25%

90000 90000

Old Partnership New Partnership

Revaluation: Goodwill Approach• Alf and Ball have capital balances of $50,000 and

$40,000 and share profit equally.• Cob enters partnerships with $50,000 payment directly

to partnership.• Cob is to have a 50% interest in the capital and income

in the new partnership.• If assets are to be revalued, the revaluation is recorded

as follows:Goodwill (or identifiable net assets) (+A) 10,000

Alf capital (+OE)5,000

Bal capital (+OE)5,000

Revaluation: Goodwill Approach

• Goodwill of $10,000 gives Alf and Ball capital balances of $55,000 and $45,000.• If equals amounts of capital are to be transferred to

Cob, the entry is the following:

Alf capital (-OE) 25,000Ball capital (-OE) 25,000

Cob capital (+OE)50,000


• The capital balances are summarized as follows:

Before Revaluation Revaluation After

RevaluationCapital

TransferredCapital After

TransferAlf $50,000 $5,000 $55,000 $-25,000 $30,000 30%Ball 40,000 5,000 45,000 -25,000 20,000 20%Cob 50,000 50,000 50%

$90,000 $10,000 $100,000 0 $100,000


• Realign the capital of Alf and Ball in the new partnership – 25% interest each.• The admission Cob would be:





Before Revaluation

RevaluationGoodwill

After Revaluation

Capital Transferred

Capital After Transfer

Alf $50,000 $5,000 $55,000 $-30,000 $25,000 25%Ball 40,000 5,000 45,000 -20,000 25,000 25%Cob 50,000 50,000 50%

$90,000 $10,000 $100,000 0 $100,000

Nonrevaluation: Bonus Approach• If the assets of the new partnership is not to be

revalued, but equal amounts of capital are to be transferred to Cob.• Alf and Ball transfer equal amounts of capital and

rights to future income to Cob, receiving $25,000 cash from Cob.• Each receives $2,500 excess ($25,000 capital received

less $22,500 capital transferred).• The entry is:

Alf capital (-OE) 22,500Bal capital (+OE) 22,500


Nonrevaluation: Bonus Approach

Per Books Capital Transferred


Alf $50,000 $-22,500 $27,500 30.6%Ball 40,000 -25,500 17,500 19.4%Cob 45,000 45,000 50.0%

$90,000 0 $90,000



• If Alf and Ball want their recorded capital and income interests in the new partnership to be equal (25%) – Alf would receive $30,000 and Ball would receive $20,000 from Cob• The entry is:






Alf $50,000 $-27,500 $22,500 25%Ball 40,000 -17,500 22,500 25%Cob 45,000 45,000 50%

$90,000 0 $90,000

• A summary of the capital balances:

Investing in an Existing Partnership

An new partner into an existing partnership – investing cash or other cash.The net assets contributed by the old partners’ partnership may or may not be revalued.The investment could be identified to assets (based on appraisal or other valuation technique).

Partnership Investment at Book Value

Dre and boy have $40,000 capital balances each and share profit equally.Agree to admit Cry to a one-third interest in capital and profit in Dre, boy, and Cry partnership – $40,000 investment.The investment ($40,000) is equal to the capital interest [($80,000 + $40,000)/3] Investment entry:

Cash (+A) 40,000Cry capital (+OE)

40,000

To record Cry’s $40,000 cash investment for a one-third interest in partnership capital and income.

Partnership Assets Revalued(Goodwill to Old Partners)

Cry invests $50,000 for a one-third interest in capital and profit.The old partnership had unrecorded asset values (fair value from Cry’s investment).$150,000 implied – $80,000 recorded assets= 70,000The unrecorded asset = $20,000. [ 70,000 – 50,000 ]


The entries:

Goodwill (+A) 20,000Dre capital (+OE)

10,000Boy capital (+OE)

10,000

To revalue the assets contributed by the old partnership based on the value of Cry’s investment.Cash (+A) 50,000

Cry capital (+OE)50,000

To record Cry’s investment for a one-third interest in partnership capital and income.


Before Revaluation

Revaluation After Revaluation

Capital Transferred


Dre $40,000 $10,000 $50,000 $50,000 1/3

Boy 40,000 10,000 50,000 50,000 1/3

Cry $50,000 50,000 1/3

$80,000 $20,000 $100,000 $50,000 $150,000


Partnership Assets Not Revalued(Bonus to Old Partners)

Partnership net assets are increased by the amount of new investment.New capital account is credited for one-third interest in the $130,000 ($80,000 book value plus $50,000 Cry’s contribution) = $130,000/3 = $43,334

Cash (+A) 50,000Dre capital (+OE)

3,333Boy capital (+OE)

3,333Cry capital (+OE)

43,334

To record Cry’s investment in the partnership and to allow Dre and Boy a bonus due to unrecorded asset values.



Dre $40,000 $3,333 $43,333 1/3Boy 40,000 3,333 43,333 1/3Cry 43,334 43,334 1/3

$80,000 $50,000 $130,000


Partnership Assets Not Revalued(Bonus to Old Partners)

Partnership Assets Revalued(Goodwill to New Partner)

Dre and Boy agreed to admit Cry – a 40% interest in capital and profit with $50,000 investment (Cry brings goodwill).Dre and Boy must be will to admit Cry to a 40% interest in the $80,000 recorded assets + $50,000 investment (40% X $130,000 = $52,000).Total capital in the new partnership is $133,333 ($80,000 : 60%)

Cash (+A) 50,000Goodwill (+A) 3,333


To admit Cry to a 40 percent interest in capital and profits.



Dre $40,000 $40,000 30%Boy 40,000 40,000 30%Cry $53,333 53,333 40%

$80,000 $53,333 $133,333


Partnership Assets Revalued(Goodwill to New Partner)

Partnership Assets Not Revalued(Bonus to New Partner)

The bonus procedure can be used to ensure – the beginning partnership capital balances reflect the profit sharing arrangement percentage.Total assets of the new partnership: $130,000 ($80,000 by Dre and Boy + $50,000 by Cry).Cry’s share is $52,000, but her contribution is $50,000.The $2,000 excess – charged against existing partnersCash (+A) 50,000Dre capital (-OE) 1,000Boy capital (-OE) 1,000


To admit Cry ‘s investment of $50,000 for a 40% interest in the partnership and allow her a $2,000 bonus

Partnership Assets Not Revalued(Bonus to New Partner)

Per Books Investment Capital After Transfer

Dre $40,000 $(1,000) $39,000 30%Boy 40,000 (1,000) 39,000 30%Cry $52,000 52,000 40%

$80,000 $52,000 $130,000


Value a partner’s upon retirement or death

Dissociation of a Continuing Partnership through Death or Retirement

Disassociation because of death or retirement – settlement with the retiring partner or the estate of the deceased partner.Valuation models could be used to determine the value of the entire business.The retiring partner – paid an amount equal to the final balance of capital account, the entry is a charge to the capital account and a credit to cash.If the settlement with a retiring partner is more or less than the final capital account balance, the revaluation (goodwill) and nonrevaluation (bonus) provide alternate methods.

Excess Payment to Retiring PartnerIllustration:Ann, Mick, and Just are partners with profit sharing percentage of 40%, 30%, and 40%. Just decides to retire. The capital and interests of the three partners on the date of Just’s retirement are as follows

Capital Balances ($)

Percentage of Capital (%)

Profit and Loss Percentage (%)

Ann 70,000 35 40Mick 50,000 25 20Just 80,000 40 40 Total 200,000 100 100

Excess Payment to Retiring Partner

The excess payment can be recorded by three methods:1) The retiring partner is granted a bonus2) Partnership revalued to the extent of payment to

retiring partner3) Partnership revalued based on the amount implied by

the excess payment.

Bonus to Retiring Partner(1) The partnership would record Jus’s withdrawal under the bonus procedure as follows:

Jus capital (-OE) 80,000Ann capital (-OE) 8,000Mic capital (-OE) 4,000

Cash (-A)92,000

Ann and Mic granted a $12,000 bonus to Jus – reduces their capital accounts (40:20 relative profit sharing ratios)

Goodwill Equal to Excess Payment is Recorded

(2) To record $12,000 excess of cash paid to Jus over his capital account balance as goodwill:

Jus capital (-OE) 80,000Goodwill (+A) 12,000

Cash (-A)92,000

Revaluation of Total Partnership Based on Excess Payment

(3) Revalue total partnership capital on the basis of the $12,000 excess payment.Revaluation, as follows:

Goodwill (other assets) (+A) 30,000Ann capital (+OE)

12,000Mic capital (+OE)

6,000Just capital (+OE)

12,000The partnership records Jus’s retirement as follows:Just capital (-OE) 92,000

Cash92,000

Payment to Retiring Partner Less than Capital Balance

Just is paid $72,000 in final settlement of his capital interest.The three partners may have agreed that the business is worth less than its book value.

Overvalued Assets Written DownA retirement payment to Jus of $8,000 less than his final capital balance – overvalued by $20,000 [($80,000 - $72,000) : 40%]The overvalued should be identified and reduced to their fair values.


The partnership records the revaluation and payment to Jus as follows:

Ann capital (-OE) 8,000Mic capital (-OE) 4,000Jus capital (-OE) 8,000

Net assets (-A)20,000

Jus capital (-OE) 72,000Cash (-A)

72,000

Bonus to Continuing PartnersThe partnership records the revaluation and payment to Jus as follows:

Jus capital (-OE) 80,000Ann capital (+OE) [8000 * (4/6)]

5,333Mic capital (+OE) [8,000 * (2/6)]

2,667Cash (-A)

72,000


Source:

BAKER CHRISTENSEN COTTLRELLAdvanced Financial Accounting 9th

BEAMS, ANTHONY, BETTINGHAUS, & SMITHAdvanced Financial Accounting 11th

Edited by T. LaCoursiere (notation added)

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