Advanced Accounting Chapter 9 2020

Chapter 16
Partnerships –
Formation, Operations,
and Changes in
Ownership Interests
to accompany
Advanced Accounting, 11th edition
by Beams, Anthony, Bettinghaus, and Smith
Copyright ©2012 Pearson Education,

16-1
Inc. 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.

16-2
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.

16-3
Partnerships – Formation, Operations, and Changes in
Ownership Interests
1: PARTNERSHIP
CHARACTERISTICS

16-4
Partnership 12-1
A partnership is an association of
two or more individuals who own
and manage a business for profit.
Advantages Disadvantages
• More financial • Limited life
resources than a • Unlimited liability
proprietorship • Co-ownership of
• Additional partnership property
management skills • Mutual agency
5
Characteristics of Partnerships
Voluntary
Voluntary Limited
Limited
Association
Association Life
Life
Partnership
Partnership
Agreement
Agreement
Taxation
Taxation
Mutual
Mutual Unlimited
Unlimited
Agency
Agency Liability
Liability
Partnership 12-1
 An important right of partners is to

participate in the income of the
partnership.
 A partnership, like a proprietorship, is a
nontaxable entity.
 A partnership is created by a contract,
known as the partnership agreement or
articles of partnership.
7
Limited Partnership 12-1
A variant of the regular

partnership is a limited
partnership. This form of
partnership allows partners who
are not involved in the
operations of the partnership to
retain limited liability.
8
Limited Liability Companies 12-1
 Combines the advantages of the corporate

and partnership forms.
 LLCs must file “articles of organization”
with state governmental authorities.
 Owners are termed “members” rather than
“partners.”
 Members must create an operating
agreement.
(Continued) 9
9
Limited Liability Companies 12-1
 An LLC may elect to be treated as a

partnership for tax purposes.
 Most operating agreements specify
continuity of life for the LLC, even when
a member withdraws.
 Members may elect operating the LLC as
a “member-managed” entity.
 An LLC provides limited liability for the
members.
10
Organizations with Partnership
Characteristics
Limited
Limited
Limited
Limited
Limited
Limited Liability
Liability
Liability
Liability
Partnerships
Partnerships Corporation
Corporation
Partnerships
Partnerships ss
•• General
Generalpartners
partners •• Protects
Protectsinnocent
innocent •• Owners
Ownershavehavesame
same
assume
assumemanagement
management partners
partnersfrom
from limited
limitedliability
liability
duties
dutiesandandunlimited
unlimited malpractice
malpracticeoror feature
featureasasowners
ownersofof
liability
liabilityfor
for negligence
negligenceclaims.
claims. aacorporation.
corporation.
partnership
partnershipdebts.
debts.
•• Limited
Limitedpartners
partners •• Most
Moststates
stateshold
holdall
all •• AAlimited
limitedliability
liability
have
haveno nopersonal
personal partners
partnerspersonally
personally corporation
corporationtypically
typically
liability
liabilitybeyond
beyond liable
liablefor
forpartnership
partnership has
hasaalimited
limitedlife.
life.
invested
investedamounts.
amounts. debts.
debts.
Choosing a Business Form
Proprietorship Partnership LLP LLC S Corp. Corporation
Business entity yes yes yes yes yes yes
Legal entity no no no yes yes yes
Limited liability no no limited* yes yes yes
Business taxed no no no no no yes
One owner allowed yes no no yes yes yes
*A partner's personal liability for LLP debts is lim ited. Most LLPs carry insurance to protect against
m alpractice.
Many
Many factors
factors should
should
be
be considered
considered when
when
choosing
choosing the
the proper
proper
business
business form.
form.
Characteristics of 12-1
2 Proprietorships, Partnerships,
and Limited Liability companies
Ease of Formation
Proprietorship Simple
Partnership Moderate
LLC Moderate
11
13
Legal Liability
Proprietorship No limitation
Partnership No limitation
LLC Limited liability
12
14
Taxation
Proprietorship Nontaxable*
Partnership Nontaxable*
LLC Nontaxable**
*Pass-through entity
**Pass-through entity by election
13
15
Limitation on Life of Entity

Proprietorship Yes
Partnership Yes
LLC No
14
16
Access to Capital
Proprietorship Limited
Partnership Limited
LLC Average
15
17
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
16-18
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. Dissolution procedures
16-19
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

16-20
Ownership Interests
2: INITIAL INVESTMENT

16-21
Organizing a Partnership
Partners
Partners can
can invest
invest both
both assets
assets and
and liabilities
liabilities
in
in the
the partnership.
partnership.
Assets
Assets and
and liabilities
liabilities are
are recorded
recorded at
at an
an agreed-
agreed-
upon
upon value,
value, normally
normally fair
fair market
market value.
value.
Contributions
Contributions increase
increase the
the partner’s
partner’s
capital
capital account.
account.
Withdrawals
Withdrawals decrease
decrease the
the partner’s
partner’s
capital
capital account.
account.
Initial Investment
A partnership is started by Amy and Paul, each
investing cash.
Cash 20,000
Amy Capital 20,000
Cash 20,000
Paul Capital 20,000
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
16-23
Change From Sole Proprietorship to
Partnership
Assume that E and F form a partnership. F is to invest cash of $25,000. E has been
operating a business that is to carried on by the new partnership. Just before the
partnership is formed, balance sheet is drawn up for E’s business is as follows:
Assets Liabilities and Capital

Cash $16,200 Liabilities
Accounts Receivable $20,000 Accounts Payable $24,000
Less: allowance 1,200 18,800 Owner’s Equity
Merchandise Inventory 21,400
Supplies 1,600 E, Capital 40,400
Furniture and Fixture $12,000
Less: Accumulated
Depreciation 5,600 6,400
Total Liabilities & _______
Total assets $64,400 Owner’s Equity $64,400
======== =======

11-24
Agreement Between E and F
 E shall withdraw the cash and that the partnership

shall take over the remaining assets and assume
the liabilities.
 Accounts receivable: Bad accounts of $1,000 are to
be written off: a 4% allowance for bad debts is to
be recognized on remaining accounts.
 Merchandise Inventory: The present market value
appraised is $26,600.
 Furniture and Fixture: Replacement value is
$15,000, but the asset is assessed to be 50%
depreciated and has a sound value $7,500
 Goodwill: E is to allowed credit for goodwill of
$10,000 that is considered to be related to his
business Copyright ©2012 Pearson Education,
11-25
E’s books are retained
Allowance for Bad Debts 440
Accumulated Depreciation 5,600
Goodwill 10,000
1
Accounts Receivable 1,000
Furniture and Fixtures 4,500
E, Capital 15,740
E, Capital 16,200
Cash 16,200
Cash 25,000
F, Capital 25,000
16-26
New books are opened for partnership
Accounts Receivable 19,000
Supplies 1,600
Furniture and Fixtures
Goodwill 10,000
1
Allowance for Bad Debts 760
Accounts Payable 24,000
E, Capital 39,940
Cash 25,000
F, Capital 25,000
16-27
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
16-28
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
16-29
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.
16-30
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
16-31
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.
16-32
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.
16-33
Statement of Partners' Capital
Beginning capital + investments – drawings and/or

withdrawals + income or – loss = ending capital
16-34
Ownership Interests
3: PROFIT AND LOSS

SHARING AGREEMENTS

16-35
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
16-36
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.
16-37
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
16-38
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.

16-39
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.
16-40
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
16-41
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
Allocation: 60%(-45) = -27; 40%(-45) = -18
16-42
Ownership Interests
4: ADMITTING A NEW
PARTNER

16-43
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
16-44
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.
16-45
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 $40.
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
16-46
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.
16-47
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.
16-48
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
16-49
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
16-50
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.
16-51
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.

16-52
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.
16-53
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.

16-54
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 $1.67 $51.67
Bev 40 1.67 41.67
Cal $50 (3.34) 46.66
Total $90 $140
Cal's new capital = 1/3 of the total $140= 46.67.

Since he invests $50 cash for a $46.66 interest,
the $3.34 bonus is transferred to the old
partners. Copyright ©2012 Pearson Education,
16-55
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 1.67
Bev Capital 1.67
Cal Capital 46.66
Bonus method, bonus to old partners
16-56
Ownership Interests
5: DEATH OR RETIREMENT
OF A PARTNER

16-57
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 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

16-58
Payment to Exiting/Retiring Partner
Mo, 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.
16-59
Payment Equals Partner Capital
Owen Capital 80
Cash 80
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.
16-60
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, 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.

16-61
Excess Payment:
Bonus to Exiting Partner
Mo Capital 80
Nel Capital 8
Owen Capital 4
Cash 92
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.
16-62
Excess Payment:
Goodwill Recorded
Owen Capital 80
Goodwill 12
Cash 92
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.
16-63
Excess Payment:
Used to Revalue Partnership Capital
Goodwill 30
Mo Capital 12
Nel Capital 6
Owen Capital 12
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 92
The exiting partner is then paid the amount of
his capital account.
16-64
Ownership Interests
6: LIMITED PARTNERSHIPS

16-65
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
16-66
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16-67

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Chapter 16

Copyright ©2012 Pearson Education,

1. Comprehend the legal

Copyright ©2012 Pearson Education,

4. Value a new partner's investment in

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

 An important right of partners is to

A variant of the regular

 Combines the advantages of the corporate

 An LLC may elect to be treated as a

Limitation on Life of Entity

Financial reporting should provide for

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

If Paul invests other assets, the value of those

Assets Liabilities and Capital

Copyright ©2012 Pearson Education,

 E shall withdraw the cash and that the partnership

Use Amy’s investment to determine implied

Each partner has his/her own accounts for

Additional investments increase Capital.

Income is shared between the partners. A loss would cause

Beginning capital + investments – drawings and/or

3: PROFIT AND LOSS

Copyright ©2012 Pearson Education,

Salary allowances are generally pre-determined

* Periodic drawings are often ignored, although

Partners’ allowances for bonus, salary and

Remaining profits (or deficit) are then split

These are general procedures. The partnership

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

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,

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

Capital of $80 at the start, increases by the

Copyright ©2012 Pearson Education,

Cal's new capital = 1/3 of the total $140= 46.67.

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

Owen retires, and his partnership interest is

The Mo, Nel, and Owen partnership would be

If Owen is paid $92,000 in final settlement of

Copyright ©2012 Pearson Education,

By treating the excess payment as a bonus to

By treating the excess payment as an

Copyright ©2012 Pearson Education,

There may be any number of limited

All rights reserved. No part of this publication may be reproduced,

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