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Slide 9 -1 Chapter Nine Partnerships: Formation and Operation Mc. Graw-Hill/Irwin © The Mc. Slide 9 -1 Chapter Nine Partnerships: Formation and Operation Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -2 Economic Importance of Partnerships l The Internal Revenue Service projects that Slide 9 -2 Economic Importance of Partnerships l The Internal Revenue Service projects that in 2005, nearly 2. 7 million partnership income tax returns will be filed in the United States (Source: www. irs. gov) l Rationale: v Reducing expenses, increasing expertise and expanding services v Tax benefits v Easily created by families and friends v Required by some professions (although these restrictions are fast disappearing) Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -3 Partnership Advantages l Flexibility in defining relationships v Ownership interest and Slide 9 -3 Partnership Advantages l Flexibility in defining relationships v Ownership interest and profit distribution may not be dependent on investment v Losses may be allocated differently than profits Ease of formation and dissolution l Easier to implement a desired control format l v Not based on ownership percentage of voting shares as with corporations l Taxed on a “flow-through” (conduit) basis v The partnership itself does not pay income taxes v 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 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -4 Partnership Disadvantages Unlimited liability incurred by each partner (they are “jointly Slide 9 -4 Partnership Disadvantages Unlimited liability incurred by each partner (they are “jointly and severally” liable) l Mutual agency (each partner has the right to incur liabilities in the name of the partnership) l Inability to participate in various corporate tax benefits l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -5 Partnerships Capital Accounts The equity section of a partnership consists of Slide 9 -5 Partnerships Capital Accounts The equity section of a partnership consists of capital balances for each partner. l Profits/losses for each period are allocated to each partner’s capital account. l Withdrawals by partners reduce their capital accounts. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -6 Alternative Legal Forms Subchapter S Corporation Often referred to as an Slide 9 -6 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 tax-exempt entities and trusts Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -7 Alternative Legal Forms Limited Partnership Tax benefits of a partnership without Slide 9 -7 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -8 Alternative Legal Forms Limited Liability Partnerships. . . Most of the Slide 9 -8 Alternative Legal Forms Limited Liability Partnerships. . . Most of the characteristics of a general partnership. EXCEPT LLP laws differ from state to state. . Partners are liable only for their own acts and omissions, and the acts and omissions of those under their direct supervision. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -9 Alternative Legal Forms Limited Liability Companies. . . Classified as a Slide 9 -9 Alternative Legal Forms Limited Liability Companies. . . Classified as a partnership for tax purposes. LLC laws differ from state to state. . Owners only risk their own investments. . The number of owners is not usually restricted. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -10 Articles of Partnerships can exist even in the absence of a Slide 9 -10 Articles of Partnerships can exist even in the absence of a written partnership agreement. l The Uniform Partnership Act establishes standards and rules for partnerships. l A written agreement will supersede the UPA standards. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -11 Articles of Partnership Method for dispute settlements Method for settling a Slide 9 -11 Articles of Partnership Method for dispute settlements Method for settling a partner’s share upon withdrawal, retirement or death Mc. Graw-Hill/Irwin Profit/loss sharing percentages Put it in writing!!! Method for admitting new partners Initial contribution to be made by each partner Rights and responsibilities of partners © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -12 Articles of Partnership Business Location Withdrawal limits Method for valuing individual Slide 9 -12 Articles of Partnership Business Location Withdrawal limits Method for valuing individual contributions Mc. Graw-Hill/Irwin 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 © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -13 Accounting for Capital Contributions If the partners each contribute cash. . Slide 9 -13 Accounting for Capital Contributions If the partners each contribute cash. . . l. . . debit Cash. l. . . credit individual Partner Capital accounts. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -14 Accounting for Capital Contributions If the partners each contribute cash and Slide 9 -14 Accounting for Capital Contributions If the partners each contribute cash and other assets. . . l. . . debit Cash & Contributed Assets for FV. l. . . credit individual Partner Capital accounts. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -15 Accounting for Capital Contributions Intangible assets, such as expertise, require special Slide 9 -15 Accounting for Capital Contributions Intangible assets, such as expertise, require special consideration l Use either the Bonus Method or the Goodwill Method. l Record the tangible assets contributed. l Adjust the partner capital balances to reflect the relative value of the intangible asset. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -16 Intangible Contributions Bonus Method On 2/15/06, Greene and Redd form a Slide 9 -16 Intangible Contributions Bonus Method On 2/15/06, Greene and Redd form a partnership. They agree to equal capital balances. Greene contributes $80, 000 cash. Redd contributes land valued at $40, 000. Prepare the journal entry to set up the partnership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -17 Intangible Contributions Bonus Method Total tangible assets for the partnership are Slide 9 -17 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 Redd only contributed land worth $40, 000. Essentially, Greene has given Redd a $20, 000 bonus. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -18 Intangible Contributions Goodwill Method Record the tangible assets contributed. l Record Slide 9 -18 Intangible Contributions Goodwill Method Record the tangible assets contributed. l Record the contributed intangible asset as the difference between the contributed tangible assets and the implied value of the partnership. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -19 Intangible Contributions Goodwill Method On 2/15/06, Greene and Redd form a Slide 9 -19 Intangible Contributions Goodwill Method On 2/15/06, Greene and Redd form a partnership. They agree to equal capital balances. Greene contributes $80, 000 cash. Redd contributes land valued at $40, 000, and brings years of experience to the new business. Prepare the journal entry to set up the partnership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -20 Intangible Contributions Goodwill Method On 2/15/06, Greene and Redd form a Slide 9 -20 Intangible Contributions Goodwill Method On 2/15/06, Greene and Redd form a partnership. They agree to equal capital balances. Greene contributes $80, 000 cash. Redd contributes land valued at $40, 000, and brings years of experience to the new business. ÷ Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -21 Intangible Contributions Goodwill Method Greene’s capital account is credited for the Slide 9 -21 Intangible Contributions Goodwill Method Greene’s capital account is credited for the tangible contribution of $80, 000. Redd’s capital account is credited for the tangible contribution of $40, 000, plus the intangible contribution valued at $40, 000. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -22 Allocation of Income l The allocation of income is not necessarily Slide 9 -22 Allocation of Income l The allocation of income is not necessarily based on the relative capital balances. v It is a separately negotiated item. l Items to be allocated: Remaining income Interest on beginning capital balances Allocated compensation Mc. Graw-Hill/Irwin Bonuses © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -23 Allocation of Income Example Bell and Sutton, a retail partnership selling Slide 9 -23 Allocation of Income Example Bell and Sutton, a retail partnership selling hats, 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, Bell is credited with a bonus of $20, 000 per the partnership agreement. They share income 40: 60 (Bell: Sutton). What are the ending capital balances for each partner? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -24 Allocation of Income Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Slide 9 -24 Allocation of Income Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -25 Allocation of Income Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Slide 9 -25 Allocation of Income Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -26 Allocation of Income Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Slide 9 -26 Allocation of Income Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -27 Allocation of Income Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Slide 9 -27 Allocation of Income Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -28 Legal Dissolution l Any alteration in the specific individuals composing a Slide 9 -28 Legal Dissolution l Any alteration in the specific individuals composing a partnership automatically leads to “legal dissolution” v Departures v Retirement v Death v Admission of a New Partner • Promotions • Buy-ins Frequently this leads to the immediate formation of a new partnership as the business continues l Can lead to termination and liquidation l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Admission of a New Partner The Rights of a Partner Slide 9 -29 An Admission of a New Partner The Rights of a Partner Slide 9 -29 An individual partner’s ownership rights include: The right to co-ownership in the business property. l The right to share in profits and losses as specified in the partnership agreement l The right to participate in the management of the business. l Mc. Graw-Hill/Irwin These two rights can be sold (unless restricted by the articles of partnership) This right cannot be sold without the other partners’ approval. © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -30 Partnership Dissolution Admission of a New Partner When the makeup of Slide 9 -30 Partnership Dissolution Admission of a New Partner When the makeup of the partnership changes, the partnership is dissolved. l A new partnership is immediately formed. l New partner acquires partnership interest by: l v Purchasing it from the other partners, or v Making a contribution to the partnership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -31 Admission of a New Partner Purchase of a Current Interest l Slide 9 -31 Admission of a New Partner Purchase of a Current Interest l A new partner can purchase partnership interest directly from the existing partners. v The cash goes to the partners, not to the partnership. l Two methods are available to account for the transfer of ownership. v Book Value Approach v Goodwill (Revaluation) Approach Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -32 Admission of a New Partner Purchase of a Current Interest Book Slide 9 -32 Admission of a New Partner Purchase of a Current Interest Book Value Example l Doe, Raye, and Mee have a partnership. l Mc. Graw-Hill/Irwin Using the Book Value Approach, prepare the entry assuming Flatt pays $60, 000 directly to the other partners for a 20% partnership interest. © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -33 Admission of a New Partner Purchase of a Current Interest Book Slide 9 -33 Admission of a New Partner Purchase of a Current Interest Book Value Example The cash goes to Doe, Raye, and Mee, NOT to the partnership. l Each partner gives up 20% of their existing capital. l Prepare the journal entry to admit Flatt to the partnership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -34 Admission of a New Partner Purchase of a Current Interest Book Slide 9 -34 Admission of a New Partner Purchase of a Current Interest Book Value Example The cash goes to Doe, Raye, and Mee, NOT to the partnership. l Each partner gives up 20% of their existing capital. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -35 Admission of a New Partner Purchase of a Current Interest Now, Slide 9 -35 Admission of a New Partner Purchase of a Current Interest Now, let’s take a look at the Goodwill (Revaluation) Approach. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -36 Admission of a New Partner Purchase of a Current Interest Goodwill Slide 9 -36 Admission of a New Partner Purchase of a Current Interest Goodwill (Revaluation) Example l Doe, Raye, and Mee have a partnership. l Mc. Graw-Hill/Irwin Using the Goodwill Approach, prepare the entry assuming Flatt pays $60, 000 directly to the other partners for a 20% partnership interest. © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -37 Admission of a New Partner Purchase of a Current Interest Goodwill Slide 9 -37 Admission of a New Partner Purchase of a Current Interest Goodwill (Revaluation) Example The implied value of the partnership is $300, 000 v $60, 000 ÷ 20% = $300, 000 l First, compute the Goodwill l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -38 Admission of a New Partner Purchase of a Current Interest Goodwill Slide 9 -38 Admission of a New Partner Purchase of a Current Interest Goodwill (Revaluation) Example Allocate the $160, 000 of Goodwill to the existing partners, based on their income sharing %. (40: 25: 35) Prepare the journal entry to allocate goodwill to Doe, Raye, & Mee. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -39 Admission of a New Partner Purchase of a Current Interest Goodwill Slide 9 -39 Admission of a New Partner Purchase of a Current Interest Goodwill (Revaluation) Example Allocate the $160, 000 of Goodwill to the existing partners, based on their income sharing %. (40: 25: 35) Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -40 Admission of a New Partner Purchase of a Current Interest Goodwill Slide 9 -40 Admission of a New Partner Purchase of a Current Interest Goodwill (Revaluation) Example The new balances for Doe, Raye, and Mee appear as follows: Next, allocate 20% from each of the existing partners to Flatt. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -41 Admission of a New Partner Purchase of a Current Interest Revaluation Slide 9 -41 Admission of a New Partner Purchase of a Current Interest Revaluation Example Note that Flatt’s balance, after allocation from the current partners, equals Flatt’s contribution of $60, 000. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -42 Admission of a New Partner Contribution to the Partnership l l Slide 9 -42 Admission of a New Partner Contribution to the Partnership l l l 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: v Bonus Approach v Goodwill Approach Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -43 Admission of a New Partner Contribution to the Partnership Bonus Example Slide 9 -43 Admission of a New Partner Contribution to the Partnership Bonus Example l Doe, Raye, and Mee have a partnership. l Mc. Graw-Hill/Irwin Using the Bonus Approach, prepare the entry assuming Flatt pays $60, 000 to the partnership for a 20% partnership interest. © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -44 Admission of a New Partner Contribution to the Partnership Bonus Example Slide 9 -44 Admission of a New Partner Contribution to the Partnership Bonus Example Net assets after the contribution are $200, 000. l Flatt gets credit for 20% of net assets ($200, 000 x 20%). l The remainder of the $60, 000 contribution is allocated to the other partners. l Note that the $200, 000 results from the net assets of the partnership of $140, 000 + Flatt’s $60, 000 contribution. Mc. Graw-Hill/Irwin Prepare the journal entry. © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -45 Admission of a New Partner Contribution to the Partnership Bonus Example Slide 9 -45 Admission of a New Partner Contribution to the Partnership Bonus Example Net assets after the contribution are $200, 000. l Flatt gets credit for 20% of net assets ($200, 000 x 20%). l The remainder of the $60, 000 contribution is allocated to the other partners. l Note that the $200, 000 results from the net assets of the partnership of $140, 000 + Flatt’s $60, 000 contribution. Mc. Graw-Hill/Irwin Prepare the journal entry. © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -46 Admission of a New Partner Contribution to the Partnership Now, let’s Slide 9 -46 Admission of a New Partner Contribution to the Partnership Now, let’s take a look at the Goodwill Approach. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -47 Admission of a New Partner Contribution to the Partnership Goodwill Example Slide 9 -47 Admission of a New Partner Contribution to the Partnership Goodwill Example l Doe, Raye, and Mee have a partnership. l Mc. Graw-Hill/Irwin Using the Goodwill Approach, prepare the entry assuming Flatt pays $60, 000 to the partnership for a 20% partnership interest. © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -48 Admission of a New Partner Contribution to the Partnership Goodwill Example Slide 9 -48 Admission of a New Partner Contribution to the Partnership Goodwill Example Net assets after the contribution are $200, 000. l Implied value of the partnership is $300, 000. l v $60, 000 ÷ 20% = $300, 000 l Goodwill to be recorded is $100, 000 (300, 000 - 200, 000) Prepare the journal entry to allocate goodwill to Doe, Raye, & Mee. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -49 Admission of a New Partner Contribution to the Partnership Goodwill Example Slide 9 -49 Admission of a New Partner Contribution to the Partnership Goodwill Example Net assets after the contribution are $200, 000. l Implied value of the partnership is $300, 000. l v $60, 000 ÷ 20% = $300, 000 l Goodwill to be recorded is $100, 000 (300, 000 - 200, 000) Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -50 Admission of a New Partner Contribution to the Partnership Goodwill Example Slide 9 -50 Admission of a New Partner Contribution to the Partnership Goodwill Example After allocating the goodwill to the original partners, record Flatt’s cash contribution and credit Flatt’s capital account. Prepare the journal entry to admit Flatt to the partnership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -51 Admission of a New Partner Contribution to the Partnership Goodwill Example Slide 9 -51 Admission of a New Partner Contribution to the Partnership Goodwill Example After allocating the goodwill to the original partners, record Flatt’s cash contribution and credit Flatt’s capital account. Prepare the journal entry to admit Flatt to the partnership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -52 Summary A partnership is defined as “an association of two or Slide 9 -52 Summary A partnership is defined as “an association of two or more persons to carry on a business as co-owners for profit. ” l This form of business organization is popular for many reasons, primarily ease of formation and organization l There are tax benefits as a result of their flow-through nature l Disadvantages include unlimited liability and mutual agency l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -53 Possible Criticisms l Because corporations can be considered “persons” for purpose Slide 9 -53 Possible Criticisms l 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 l Others argue that unlimited liability and mutual agency provisions are too strict and unduly limit commerce WHAT DO YOU THINK? ? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007

Slide 9 -54 End of Chapter 9 Accounting for my partners is easy. It’s Slide 9 -54 End of Chapter 9 Accounting for my partners is easy. It’s accounting for their taste that I find difficult! Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007