CHP 16 - Partnerships - Formation

Chapter 16
Partnerships – Formation,
Operations, and Changes in
Ownership Interests
Copyright ©2012 Pearson Education, Inc.

16-1 Publishing as Prentice Hall
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.

Publishing as Prentice Hall 16-2
Partnerships: Objectives (cont.)
4. Value a new partner's investment in an

existing partnership.

1: partnership characteristics
Partnerships – Formation, Operations, and Changes in
Ownership Interests

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

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 withdrawals
6. Profit and loss sharing
7. Copyright
Dissolution procedures
©2012 Pearson Education, Inc.
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

Ownership Interests
2: initial investment

Initial Investment
A partnership is started by Amy and Paul, each
investing cash.
Cash XXX
Amy Capital XXX
Cash XXX
Paul Capital XXX
If Paul invests other assets, the value of those

assets should be agreed upon in advance.
Cash XXX
Equipment XXX
Land XXX
Paul Capital XXX
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
Initial Investment with Bonus
Total 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 35
Land 10
Building 40
Amy Capital 46
Paul Capital 46
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 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.
Initial Entry with Goodwill
Paul's 50%($100) $50
Amy's 50%($100) $50 He invests:
She invests: Cash $7
Land $10 Inventory $35 $42
Building $40 $50 Goodwill $8
Land 10
Building 40
Amy Capital 50
To record Amy's investment
Cash 7
Inventory 35
Goodwill 8
Paul Capital 50
To record Paul's investment and goodwill
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.
Sample Partner Closing Entries
Amy Capital XXX
Amy Drawings XX
Drawings / Amy Withdrawals XX
withdrawals
are closed to Reduces Amy's capital for drawings and withdrawals
individual Paul Capital XXX
capital Paul Drawings XXX
accounts.
Income Summary Profit
Amy Capital XXX
Paul Capital XXX
To share profits between Amy and Paul
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.
Statement of Partners' Capital
Beginning capital + investments – drawings and/or

withdrawals + income or – loss = ending capital
3: profit and loss sharing agreements
Ownership Interests

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

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.
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
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.

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
Copyright ©2012 Pearson are $660 for the year.
Education, Inc.
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
Example: Sharing Profits (cont.)
Assume instead that income was only $180.
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
16-24
Allocation: 60%(-45)
Copyright ©2012 Pearson = -27; 40%(-45) = -18
Education, Inc.
Publishing as Prentice Hall
Ownership Interests
4: admitting a new partner

Admitting a New Partner
There 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
Assignment
Assignment 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.
Buy from Partner: Simple
Abby 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.
Abby Capital 25
Cobb Capital 25
Before After
Capital Share Capital Share
Abby $50 50% $25 25%
Bing 50 50% 50 50%
Cobb 25 25%
Total $100 $100
Buy from Partner: Goodwill
Dawn 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.
Implied value of firm, $60/.50 120
Old capital, $50 + 40 90
Goodwill 30
The goodwill increases Dawn & Ed's capital by
$15 each.
Buy from Partner: Goodwill (cont.)
After
Before Revaluation revaluation Transfer Final
Dawn $50 $15 $65 ($35) $30
Ed 40 15 55 (25) 30
Fay 60 60
Total $90 $120 $120
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.
Buy from Partner: Bonus
If Dawn and Ed had decided not to revalue the
assets or record goodwill, the bonus method is
used. Before Transfer Final
Dawn $50 ($27.5) $22.5
Ed 40 (17.5) 22.5
Fay 45.0 45.0
Total $90 $90.0
Fay's capital is 50%(90) = $45.

Dawn and Ed Capital accounts are adjusted to
their new balances 25%(90) = $22.5
Entries for Purchase from Partner
Entries for Fay's admission, under goodwill
and bonus methods:
Goodwill 30
Dawn Capital 15
Ed Capital 15
Dawn Capital 35
Ed Capital 25
Fay Capital 60
Goodwill method, aligning capital accounts
Dawn Capital 27.5
Ed Capital 17.5
Fay Capital 45
Bonus method, aligning capital accounts
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.
Goodwill to Old Partners (cont.)
Re- After re-
Before valuation valuation Investment Final
Al $40 $10 $50 $50
Bev 40 10 50 50
Cal $50 50
Total $80 $100 $150
Capital of $80 at the start, increases by the

$20 goodwill and the $50 cash investment.

Goodwill to New Partner
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) $133.3
Old 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.
Goodwill to New Partner (cont.)
Re- After re-
Before valuation 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
Capital of $80 at the start, increases by the

$3.3 goodwill and the $50 cash investment.

New Partner Investment: Bonus
Al and Bev decide not to revalue the business
assets, and Cal invests $50 cash in the
business for a 1/3 interest.
Before Investment Bonus Final
Al $50 ($1) $49
Bev 40 (1) 39
Cal $50 2 52
Total $90 $140
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.
Entries for Investment in Business
Entries for Cal's investment, under goodwill
and bonus methods:
Goodwill 20
Al Capital 10
Bev Capital 10
Cash 60
Cal Capital 60
Goodwill method, goodwill to old partners
Cash 50
Al Capital 1
Bev Capital 1
Cal Capital 52
Bonus method, bonus to new partner

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CHP 16 - Partnerships - Formation

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Chapter 16

Copyright ©2012 Pearson Education, Inc.

1. Comprehend the legal characteristics of

Copyright ©2012 Pearson Education, Inc.

4. Value a new partner's investment in an

Copyright ©2012 Pearson Education, Inc.

Copyright ©2012 Pearson Education, Inc.

Copyright ©2012 Pearson Education, Inc.

Copyright ©2012 Pearson Education, Inc.

Copyright ©2012 Pearson Education, Inc.

If Paul invests other assets, the value of those

Use Amy’s investment to determine implied

Additional investments increase Capital.

Drawings and withdrawals reduce Capital.

Income Summary (Revenue and Expense Summary) is

Income is shared between the partners. A loss would cause

Beginning capital + investments – drawings and/or

Copyright ©2012 Pearson Education, Inc.

Copyright ©2012 Pearson Education, Inc.

Salary allowances are generally pre-determined

* Periodic drawings are often ignored, although

Remaining profits (or deficit) are then split

These are general procedures. The partnership

Copyright ©2012 Pearson Education, Inc.

Copyright ©2012 Pearson Education, Inc.

Note that this means one partner can not make

Presumably, Fay paid $35 to Dawn and $25 to Ed.

If the partners had not wanted to realign the

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

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

Capital of $80 at the start, increases by the

Copyright ©2012 Pearson Education, Inc.

Cal: $130*40% = $52, but he pays $50 … so goodwill goes

Capital of $80 at the start, increases by the

Copyright ©2012 Pearson Education, Inc.

Cal's new capital = 1/3 of the total $140. Since

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