Chapter 16

Partnerships –
Formation,
Operations, and
Changes in
Ownership
Interests
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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Partnerships: Objectives (cont.)

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.

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 Partnerships – Formation, Operations, and Changes
in Ownership Interests

1: PARTNERSHIP
CHARACTERISTICS

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Partnerships
RUPA "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 partnership

Partners 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 Partnership
The partnership agreement should specify:
1. Products or services, line of business
2. Partner rights and responsibilities
3. Initial investment and value assigned to
noncash investments
4. Additional investment conditions
5. Asset withdrawal provisions
6. Profit and loss sharing
7. 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
information returns allow the IRS to
verify that each partner pays income
taxes on his/her share of partnership
income

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 Partnerships – Formation, Operations, and Changes in
Ownership Interests

2: INITIAL INVESTMENT

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Initial Investment

A partnership is started by Ash and Bec,

each investing cash.
Cash 20,000
Ash Capital 20,000
Cash 20,000
Bec Capital 20,000

If Bec invests other assets, the value of those

assets should be agreed upon in advance.
Cash XXX
Equipment XXX
Land XXX
Bec Capital XXX

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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 Bonus
Total fair value received is split, as desired, between
partner capital accounts.

For example: Col contributes assets of $50,000, and

Cro contributes assets of $42,000. They agree to
have equal shares: 92 / 2 = $46 each.

Col Cro
Cash 7
Cash - 7,000
Inventory 35
Land 10,000 -
Land 10
Building 40,000 - Building 40
Inventory items - 35,000 Col, Capital 50
Total 50,000 42,000 Cro, Capital 42

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• Increase Cro’s capital and decrease Col’s
capital by $4,000.

Col, Capital 4,000

Cro, Capital 4,000

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Initial Investment with Goodwill
The 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 Col and Cro partnership:
Col's: (10 + 40) / 50% = $100
Cro's: (7 + 35) / 50% = $84

Use Col’s investment to determine implied

value of firm -- $100.
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Initial Entry with Goodwill
Cro's 50% ($100) $50
Col's 50%($100) $50 He invests:
He invests: Cash $7
Land $10 Inventory $35 $42
Building $40 $50
Goodwill $8

Goodwill 8,000
Cro, Capital 8,000

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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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 Partner Closing Entries
Revenue and Expense Summary 34,500
Rat capital 20,700
Drawings /
withdrawals Yan capital 13,800
are closed
to individual
capital Rat capital 6,000
accounts. Yan capital 9,000
Rat drawing 6,000
Yan drawing 9,000

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

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 Partnerships – Formation, Operations, and Changes in
Ownership Interests
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 (in addition to time
and investment given)

– 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, 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 Profits
Lot 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.)
  Total Lot Babel
Net 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

Bonus = 50%(660 - 500) = 80

Lot Interest = 10%(400) = 40
Babel Interest = 10%(350) = 35
Allocation: 60%(415) = 249; 40%(415) = 166

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Example: Sharing Profits (cont.)
Assume instead that income was only $120.
  Total Lot Babel
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 $500)

Lot Interest = 10%(400) = 40
Babel Interest = 10%(350) = 35
Allocation: 60%(-45) = -27; 40%(-45) = -18
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 Partnerships – Formation, Operations, and Changes
in Ownership Interests

4: ADMITTING A NEW
PARTNER

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Admitting a New Partner
Methods of entry for a new partner into an
existing partnership:

1. New partner purchases interest from

existing partner(s).
• Goodwill method
• Bonus method
2. New partner invests directly in
partnership.
• Goodwill method
• Bonus method

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 Buy from Partner: Simple
Alf and Bal have capital balances of $50k each and
each have a 50% interest in the firm.
Cob buys half of Alf's interest for $25.

Alf Capital 25
Cob Capital 25

  Before After
  Capital Share Capital Share
Alf $50 50%   $25 25%
Bal 50 50%   50 50%
Cob       25 25%
Total $100     $100  

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Buy from Partner: Goodwill

Alf and Bal have capital of $50 and $40,

each with 50% interest.
Cob will pay $50 directly to the partners and
receive 50% interest in the firm. Alf and Bal
each keep 25%. Assets are at fair value.
Implied value of firm, $50/.50 100
Old capital, $50 + 40 90
Goodwill 10

The goodwill increases Alf & Bal's capital by

$5 each.

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Buy from Partner: Goodwill
(cont.)
Revaluatio After
  Before n revaluation Transfer Final
Alf $50 $5 $55 ($25) $30
Bal 40 5 45 (25) 20
Cob       50  50
Total $90 $100 $100

Presumably, Cob paid $25 to Alf and $25 to Bal.

If the partners had decided to realign the capital, the

capital of Alf and Bal would be reduced by $30 and $20
respectively to transfer the $50 to Cob.
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Buy from Partner: Bonus
If Alf and Bal had decided not to revalue the
assets or record goodwill, the bonus method
is used.

Before Transfer Final

Alf $50 ($22.5) $27.5
Bal 40 (22.5) 17.5
Cob   45.0  45.0
Total $90 $90.0

Cob's capital is 50%(90) = $45.

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Entries for Purchase from
Partner
Entries for Fay's admission, under goodwill and
bonus methods:
Goodwill 10
Alf Capital 5
Bal Capital 5
Alf Capital 25
Bal Capital 25
Cob Capital 50
Goodwill method, aligning capital accounts

Alf Capital 22.5

Bal Capital 22.5
Cob Capital 45
Bonus method, not aligning capital accounts

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New Partner Investment:
Goodwill to Old Partners
Dre and Boy each have capital balances of
$40 and share equally in the firm. Cry 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

Cry: $130*1/3 = $43.3, but he pays $50 … so

goodwill goes to old partners. Implied firm value is
based on Cry's investment.
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New Partner Investment:
Goodwill to Old Partners (cont.)

Re- After re-

  Before valuation valuation Investment Final
Dre $40 $10 $50   $50
Boy 40 10 50   50
Cry       $50 50
Total $80 $100 $150

Capital of $80 at the start, increases by the

$20 goodwill and the $50 cash investment.

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New Partner Investment:
Goodwill to New Partner
Dre and Boy each have capital balances of
$40 and share equally in the firm. Cry will
be admitted with an investment of $50 cash.
Cry will be given a 40% share; Dre and Boy
will each have 30%, and net assets are at
fair value. Goodwill will be recorded.
Implied value of firm, $80/(.60)   $133.3
Old capital, $40 + 40 $80  
Additional investment 50 130.0
Goodwill   $3.3

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

Re- After re-

  Before valuation valuation Investment Final
Dre $40 $40   $40.0
Boy 40 40   40.0
Cry   $3.3  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.

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New Partner Investment:
Bonus
Dre and Boy decide not to revalue the business
assets, and Cry invests $50 cash in the business for
a 1/3 interest.
Before Investment Bonus Final
Dre $40 ($1) $39
Boy 40 (1) 39
Cry   $50 2  52
Total $80 $130

Cry'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.

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Entries for Investment in
Business
Entries for Cry's investment, under goodwill and
bonus methods:
Goodwill 20
Dre Capital 10
Boy Capital 10
Cash 60
Cry Capital 60
Goodwill method, goodwill to old partners

Cash 50
Dre Capital 1
Boy Capital 1
Cry Capital 52
Bonus method, bonus to new partner

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 Partnerships – Formation, Operations, and Changes in
Ownership Interests

5: DEATH OR RETIREMENT
OF A PARTNER

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Dissociation

Firm value, according to the Uniform Partnership

Act, is the greater of
• Liquidation value
• Sales value as a going concern without the
dissociated partner
Payment to exiting partner may be
• Equal to retiring capital
• More than retiring capital
- Implied goodwill or bonus to retir partner
• Less than existing capital
- Write down overvalued assets, or bonus to
remaining partners

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Payment to Retiring Partner
Ann, Mic, and Jus are partners with capital
balances and profit-sharing percentages,
shown respectively, as follows:

Jus retires, and his partnership interest is

paid out by the partnership.

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Payment Equals Partner Capital

Jus Capital 80
Cash 80

The Ann, Mic, and Jus partnership would be

dissolved. Ann and Mic 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 Jus is paid $92,000 in final settlement of
his partnership interest, the excess may be
treated as
1. A bonus to Jus, or
2. 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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Excess Payment:
Bonus to Exiting Partner

Jus Capital 80
Ann Capital 8
Mic Capital 4
Cash 92

By treating the excess payment as a bonus

to Jus, Ann and Mic 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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Excess Payment:
Goodwill Recorded

Jus Capital 80
Goodwill 12
Cash 92

By treating the excess payment as an

indication that partnership assets were
undervalued, Goodwill is recorded. Note
that Ann and Mic’s capital accounts are
not revalued.

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Excess Payment: Used to
Revalue Partnership Capital
Goodwill 30
Ann Capital 12
Mic Capital 6
Jus Capital 12

The excess payment is used to determine the

implied fair value of the partnership.
$12,000 excess / Jus’s 40% share =
implied partnership under-valuation of $30,000

Jus Capital 92
Cash 92
The exiting partner is then paid the amount of his
capital account.
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 Partnerships – Formation, Operations, and Changes in
Ownership Interests

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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