Chapter 15 Partnerships Formation Operations and Changes

Chapter 15: Partnerships – Formation, Operations, and Changes in Ownership Interests by Jeanne M. David, Ph. D. , Univ. of Detroit Mercy to accompany Advanced Accounting, 10 th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn © Pearson Education, Inc. publishing as Prentice Hall 15 -1

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. © Pearson Education, Inc. publishing as Prentice Hall 15 -2

Objectives (cont. ) 5. Value a partner's share upon retirement or death. 6. Understand limited liability partnership characteristics. © Pearson Education, Inc. publishing as Prentice Hall 15 -3

Partnerships – Formation, Operations, and Changes in Ownership Interests 1: Characteristics of Partnerships © Pearson Education, Inc. publishing as Prentice Hall 15 -4

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 © Pearson Education, Inc. publishing as Prentice Hall 15 -5

Articles of Partnership 1. Products or services, line of business 2. Partner rights & responsibilities 3. Initial investment and value assigned to noncash investments 4. Additional investment conditions 5. Asset withdrawals 6. Profit and loss sharing 7. Dissolution procedures © Pearson Education, Inc. publishing as Prentice Hall 15 -6

Partnership Reporting • Financial reporting should provide for the needs of – Partners – Creditors of the partnership – IRS © Pearson Education, Inc. publishing as Prentice Hall 15 -7

Partnerships – Formation, Operations, and Changes in Ownership Interests 2: Initial Investment © Pearson Education, Inc. publishing as Prentice Hall 15 -8

Initial Investment Cash Amy Capital Cash Paul Capital XXX 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 Equipment Land Paul Capital © Pearson Education, Inc. publishing as Prentice Hall XXX XXX 15 -9

Initial Investment with Bonus or Goodwill Partner 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 © Pearson Education, Inc. publishing as Prentice Hall 15 -10

Initial Investment with Bonus Total fair value received is split, as desired, between partners Cola invests land 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 each Cash Inventory Land Building Cola Capital Crown Capital © Pearson Education, Inc. publishing as Prentice Hall 7 35 10 40 46 46 15 -11

Initial Investment with Goodwill If Cola and Crown agree to equal shares, use larger implied total value of firm. Cola's: (10 + 40) / 50% = $100 Crown's: (7 + 35) / 50% = $84 Implied value of firm $100 Cola's 50%(100) $50 He invests: Land $10 Building $40 $50 © Pearson Education, Inc. publishing as Prentice Hall Crown's 50%(100) $50 He invests: Cash $7 Inventory $35 $42 Goodwill $8 15 -12

Initial Entry with Goodwill Land 10 Building 40 Cola Capital To record Cola's investment Cash 7 Inventory 35 Goodwill 8 Crown Capital To record Crown's investment and goodwill © Pearson Education, Inc. publishing as Prentice Hall 50 50 15 -13

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. © Pearson Education, Inc. publishing as Prentice Hall 15 -14

Sample Partner Closing Entries Drawings / withdrawals are closed to individual capital accounts. Amy Capital Amy Drawings Amy Withdrawals XXX XX XX Reduces Amy's capital for drawings and withdrawals Paul Capital XXX Paul Drawings Income Summary Profit Amy Capital Paul Capital To share profits between Amy and Paul XXX XXX 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. © Pearson Education, Inc. publishing as Prentice Hall 15 -15

Statement of Partners' Capital Beginning capital + investments – drawings and/or withdrawals + income or – loss = ending capital © Pearson Education, Inc. publishing as Prentice Hall 15 -16

Partnerships – Formation, Operations, and Changes in Ownership Interests 3: Sharing Profit and Loss © Pearson Education, Inc. publishing as Prentice Hall 15 -17

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 © Pearson Education, Inc. publishing as Prentice Hall 15 -18

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 © Pearson Education, Inc. publishing as Prentice Hall 15 -19

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 © Pearson Education, Inc. publishing as Prentice Hall 15 -20

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. © Pearson Education, Inc. publishing as Prentice Hall 15 -21

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. © Pearson Education, Inc. publishing as Prentice Hall 15 -22

Share Profits of $660 Net income Salary allowance Bonus allowance Interest allowance Subtotal Split 60: 40 Allocated net income Total $660 (90) (80) (75) $415 (415) $0 Tom Betty $60 $30 0 80 40 35 249 166 $349 $311 Bonus = 50%(660 - 500) = 80 Tom Interest = 10%(400) = 40 Betty Interest = 10%(350) = 35 60%(415) = 249; 40%(415) = 166 © Pearson Education, Inc. publishing as Prentice Hall 15 -23

Share Profits of $180 Assume instead that income was only $180. Total Tom Betty Net 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 Bonus = zero, income does not exceed threshold Tom Interest = 10%(400) = 40 Betty Interest = 10%(350) = 35 60%(-45) = -27; 40%(-45) = -18 © Pearson Education, Inc. publishing as Prentice Hall 15 -24

Partnerships – Formation, Operations, and Changes in Ownership Interests 4: Admitting a New Partner © Pearson Education, Inc. publishing as Prentice Hall 15 -25

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 © Pearson Education, Inc. publishing as Prentice Hall 15 -26

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 Assignee Capital © Pearson Education, Inc. publishing as Prentice Hall XXX 15 -27

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. Alfano Capital Cobb Capital Alfano Bailey Cobb Total Before Capital Share $50 50% $100 © Pearson Education, Inc. publishing as Prentice Hall 25 25 After Capital Share $25 25% 50 50% 25 25% $100 15 -28

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. Implied value of firm, $60/. 50 120 Old capital, $50 + 40 90 Goodwill 30 The goodwill increases Don & Ed's capital each by $15. © Pearson Education, Inc. publishing as Prentice Hall 15 -29

Goodwill Revalues Capital Don Ed Fay Total After Before Revaluation revaluation $50 $15 $65 40 15 55 $90 $120 Transfer ($35) (25) 60 Final $30 30 60 $120 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. © Pearson Education, Inc. publishing as Prentice Hall 15 -30

Buy from Partner: Bonus If Don and Ed had decided not to revalue the assets or record goodwill, the bonus method is used. Don Ed Fay Total Before Transfer Final $50 ($27. 5) $22. 5 40 (17. 5) 22. 5 45. 0 $90. 0 Fay's capital is 50%(90) = $45. Don and Ed Capital accounts are adjusted to their new balances 25%(90) = $22. 5 © Pearson Education, Inc. publishing as Prentice Hall 15 -31

Entries for Purchase from Partner Entries for Fay's admission, under goodwill and bonus methods: Goodwill 30 Don Capital Ed Capital Don Capital 35 Ed Capital 25 Fay Capital Goodwill method, aligning capital accounts Don Capital 27. 5 Ed Capital 17. 5 Fay Capital Bonus method, aligning capital accounts © Pearson Education, Inc. publishing as Prentice Hall 15 15 60 45 15 -32

Invest in Business: Goodwill Andrew and Boyles have capital balances of $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 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. © Pearson Education, Inc. publishing as Prentice Hall 15 -33

Investment and Goodwill Add to Capital (Goodwill to Old Partners) Revalu- After re Before ation valuation Investment Final Andrew $40 $10 $50 Boyles 40 10 50 Criner $50 50 Total $80 $100 $150 Capital of $80 at the start, increases by the $20 goodwill and the $50 cash investment. © Pearson Education, Inc. publishing as Prentice Hall 15 -34

Invest in Business: Goodwill Andrew and Boyles have capital balances of $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 be recorded. Implied value of firm, $80/(. 60) $133. 3 Old 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. © Pearson Education, Inc. publishing as Prentice Hall 15 -35

Investment and Goodwill Add to Capital (Goodwill to New Partner) Revalu- After re Before ation valuation Investment Final Andrew $40. 0 Boyles 40 40 40. 0 Criner $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. © Pearson Education, Inc. publishing as Prentice Hall 15 -36

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. Andrew Boyles Criner Total Before Investment $50 40 $50 $90 Bonus ($1) (1) 2 Final $49 39 52 $130 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. © Pearson Education, Inc. publishing as Prentice Hall 15 -37

Entries for Investment in Business Entries for Criner's investment, under goodwill and bonus methods: Goodwill Andrew Capital Boyles Capital Cash Criner Capital Goodwill method, goodwill to old partners Cash Andrew Capital Boyles Capital Criner Capital Bonus method, bonus to new partner © Pearson Education, Inc. publishing as Prentice Hall 20 10 10 60 50 1 1 52 15 -38

Partnerships – Formation, Operations, and Changes in Ownership Interests 5: Death or Retirement of a Partner © Pearson Education, Inc. publishing as Prentice Hall 15 -39

Dissociation Firm value, according to RUPA, is the greater of – Liquidation value – Sales value as a going concern without the dissociated partner Payment 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 © Pearson Education, Inc. publishing as Prentice Hall 15 -40

Partnerships – Formation, Operations, and Changes in Ownership Interests 6: Limited Liability Partnership © Pearson Education, Inc. publishing as Prentice Hall 15 -41

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 © Pearson Education, Inc. publishing as Prentice Hall 15 -42

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