Beams 11 Ppt 16 Partnerships

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

to accompanyAdvanced Accounting, 11th edition

by Beams, Anthony, Bettinghaus, and Smith

Chapter 16

Partnerships – Formation, Operations,

and Changes in Ownership Interests

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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.


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4. Value a new partner's investment in an existing partnership.

5. Value a partner's share upon retirement or death.

6. Understand limited liability partnership characteristics.

Partnerships: Objectives (cont.)


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1: PARTNERSHIP CHARACTERISTICS

Partnerships – Formation, Operations, and Changes in Ownership Interests


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PartnershipsRUPA "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

partnershipPartners 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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Articles of PartnershipThe partnership agreement should specify:1. Products or services, line of business2. Partner rights and 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 – 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


2: INITIAL INVESTMENT

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Initial Investment

If Paul invests 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 XXXLand XXX

Paul Capital XXX

A partnership is started by Amy and Paul, each investing cash.


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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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Initial Investment with BonusTotal 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: (10 + 40 + 7 + 35) / 2 = $46 each

Cash 7 Inventory 35Land 10 Building 40

Amy Capital 46Paul Capital 46


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Initial Investment with GoodwillThe 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: (10 + 40) / 50% = $100

Paul's: (7 + 35) / 50% = $84

Use Amy’s investment to determine implied value of firm -- $100.


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Initial Entry with Goodwill

Land 10 Building 40

Amy Capital 50To record Amy's investment

Cash 7Inventory 35Goodwill 8

Paul Capital 50To record Paul's investment and goodwill

Amy's 50%($100) $50She invests: Land $10 Building $40 $50

Paul's 50%($100) $50He invests: Cash $7 Inventory $35 $42Goodwill $8


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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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Sample Partner Closing EntriesAmy Capital XXX

Amy Drawings XXAmy Withdrawals XXReduces Amy's capital for drawings and withdrawals

Paul Capital XXXPaul Drawings XXX

Income Summary ProfitAmy Capital XXXPaul Capital XXXTo 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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Statement of Partners' Capital

Beginning capital + investments – drawings and/or withdrawals + income or – loss = ending capital


3: PROFIT AND LOSS SHARING AGREEMENTS

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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 AllowancesBonus 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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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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Example: Sharing ProfitsLot 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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Example: Sharing Profits (cont.)

Bonus = 50%(660 - 500) = 80 Lot Interest = 10%(400) = 40 Babel Interest = 10%(350) = 35 Allocation: 60%(415) = 249; 40%(415) = 166

Total Lot BabelNet 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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Assume instead that income was only $180. Total Lot BabelNet 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

Example: Sharing Profits (cont.)

Bonus = zero (income does not exceed $500) Lot Interest = 10%(400) = 40 Babel Interest = 10%(350) = 35Allocation: 60%(-45) = -27; 40%(-45) = -18


4: ADMITTING A NEW PARTNER

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Admitting a New PartnerThere are three methods of entry for a new partner into an existing partnership:

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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AssignmentAssignment 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 XXX

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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Buy from Partner: SimpleAbby 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.

Before After Capital Share Capital ShareAbby $50 50% $25 25%Bing 50 50% 50 50%Cobb 25 25%Total $100 $100

Abby Capital 25Cobb Capital 25


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Buy from Partner: GoodwillDawn 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, $50 + 40 90

Goodwill 30


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Buy from Partner: Goodwill (cont.)

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.

Before RevaluationAfter

revaluation Transfer FinalDawn $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: BonusIf 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 FinalDawn $50 ($27.5) $22.5 Ed 40 (17.5) 22.5 Fay 45.0 45.0Total $90 $90.0


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Entries for Purchase from PartnerEntries for Fay's admission, under goodwill and bonus methods:Goodwill 30

Dawn Capital 15Ed Capital 15

Dawn Capital 35Ed Capital 25

Fay Capital 60Goodwill method, aligning capital accountsDawn Capital 27.5Ed Capital 17.5

Fay Capital 45Bonus method, aligning capital accounts


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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, $40 + 40 $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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Capital of $80 at the start, increases by the $20 goodwill and the $50 cash investment.

BeforeRe-valuation

After re-valuation Investment Final

Al $40 $10 $50 $50 Bev 40 10 50 50 Cal $50 50 Total $80 $100 $150

New Partner Investment: Goodwill to Old Partners (cont.)


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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) $133.3Old capital, $40 + 40 $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.

New Partner Investment: Goodwill to New Partner


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Capital of $80 at the start, increases by the $3.3 goodwill and the $50 cash investment.

BeforeRe-valuation

After re-valuation Investment Final

Al $40 $40 $40.0 Bev 40 40 40.0 Cal $3.3 3.3 $50 53.3 Total $80 $83.3 $133.3

New Partner Investment: Goodwill to New Partner (cont.)


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New Partner Investment: BonusAl 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 FinalAl $50 ($1) $49 Bev 40 (1) 39Cal $50 2 52Total $90 $140


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Entries for Investment in BusinessEntries for Cal's investment, under goodwill and bonus methods:Goodwill 20

Al Capital 10Bev Capital 10

Cash 60Cal Capital 60

Goodwill method, goodwill to old partnersCash 50Al Capital 1Bev Capital 1

Cal Capital 52Bonus method, bonus to new partner


5: DEATH OR RETIREMENT OF A PARTNER

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DissociationFirm value, according to the Uniform Partnership Act, is the greater of

Liquidation value Sales value as a going concern without the dissociated

partnerPayment 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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Payment to Exiting PartnerMo, 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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Owen Capital 80Cash 80

Payment Equals Partner Capital

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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Payment Exceeds Partner Capital

If Owen is paid $92,000 in final settlement of his partnership interest, the excess may be treated as 1. A bonus to Owen, or2. Goodwill, in the amount of the excess, or 3. A revaluation of partnership capital based

on the fair value implied by the excess.


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Mo Capital 80Nel Capital 8Owen Capital 4

Cash 92

Excess Payment: Bonus to Exiting Partner

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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Owen Capital 80Goodwill 12

Cash 92

Excess Payment: Goodwill Recorded

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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Goodwill 30Mo Capital 12Nel Capital 6Owen Capital 12

Excess Payment: Used to Revalue Partnership 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 92The exiting partner is then paid the amount of his capital account.


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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Beams 11 Ppt 16 Partnerships