Partnerships – Formation, Operations, and Changes in Ownership Interests Chapter 15

characteristics of partnerships. Learning Objective 1 Comprehend the legal characteristics of partnerships.

Partnership Characteristics It is an association of two or more persons who co-own a business for a profit. The legal life of a partnership terminates with the admission of a new partner, the withdrawal or death of a partner, voluntary dissolution by the partners, or involuntary dissolution such as bankruptcy proceedings.

Articles of Partnership A partnership may be formed by a simple oral agreement among two or more people to operate a business for profit.

Articles of Partnership Such agreements should specify: The types of products and services to be provided Each partner’s rights and responsibilities Each partner’s initial investment Additional investment conditions Asset drawing provisions Profit and loss sharing formulas Procedures for dissolving the partnership

Partnership Financial Reporting The accounting reports are designed to meet the needs of three user groups… The partners Partnership creditors Internal Revenue Service

Understand initial investment valuation and record keeping. Learning Objective 2 Understand initial investment valuation and record keeping.

Initial Investment in a Partnership Ashley and Becker each invest $20,000 cash in a new partnership. Cash 20,000 Ashley, Capital 20,000 To record Ashley’s original investment of cash Cash 20,000 Becker, Capital 20,000 To record Becker’s original investment of cash

C. Cola and R. Crown enter into a partnership. Noncash Investments C. Cola and R. Crown enter into a partnership. C. Cola R. Crown Fair Value Fair Value Cash $ — $ 7,000 Land (cost to C. Cola, $5,000) 10,000 — Building (cost to C. Cola, $30,000) 40,000 — Inventory (cost to R. Crown, $28,000) — 35,000 Total $50,000 $42,000

Noncash Investments Land 10,000 Building 40,000 C. Cola, Capital 50,000 To record C. Cola’s original investment of land and building at fair value

Noncash Investments Cash 7,000 Inventory 35,000 R. Crown, Capital 42,000 To record R. Crown’s original investment of cash and inventory items at fair value

Bonus or Goodwill on Initial Investment The partnership agreement specifies equal capital interests. Bonus Approach C. Cola, Capital 4,000 R. Crown, Capital 4,000 To establish equal capital interests of $46,000 by recording a $4,000 bonus from C. Cola to R. Crown

Bonus or Goodwill on Initial Investment Goodwill approach Goodwill 8,000 R. Crown, Capital 8,000 To establish equal capital interests of $50,000 by recognizing R. Crown’s investment of an $8,000 unidentifiable asset

Drawings Regular withdrawals are called drawings, drawing allowances, or sometimes salary allowances. Debit Drawing and credit Cash. At period end, credit Drawing and debit each partner’s Capital.

Loans and Advances Loans and advances to the partnership and accrued interest are regarded as liabilities of the partnership. Loans and advances to partners are regarded as assets of the partnership.

Partnership Operations Ratcliffe and Yancey are partners sharing profits in a 60:40 ratio, respectively.

Partnership Operations Equity Accounts, 2003 Partnership net income 2003 $34,500 Ratcliffe capital January 1, 2003 40,000 Ratcliffe additional investment 2003 5,000 Ratcliffe drawing 2003 6,000 Yancey capital January 1, 2003 35,000 Yancey drawing 2003 9,000 Yancey withdrawal 2003 3,000

Format for a Statement of Partners’ Capital Ratcliffe and Yancey Statement of Partners’ Capital For the Year Ended 12/31/2003 60% 40% Ratcliffe Yancey Total Capital balances 1/1/03 $40,000 $35,000 $75,000 Add: Additional investments 5,000 — 5,000 Deduct: Withdrawals — – 3,000 – 3,000 Deduct: Drawings – 6,000 – 9,000 –15,000 Net contributed capital 39,000 23,000 62,000 Add: Net income for 2003 20,700 13,800 34,500 Capital balances 12/31/03 $59,700 $36,800 $96,500

Closing Entries December 31, 2003 Revenue and Expense Summary 34,500 Ratcliffe, Capital 20,700 Yancey, Capital 13,800 To divide net income for the year 60% to Ratcliffe and 40% to Yancey

Closing Entries December 31, 2003 Ratcliffe, Capital 6,000 Yancey, Capital 9,000 Ratcliffe, Drawing 6,000 Yancey, Drawing 9,000 To close partner drawing accounts to capital accounts

Grasp the diverse nature of profit and loss sharing agreements Learning Objective 3 Grasp the diverse nature of profit and loss sharing agreements and their computation.

Profit and Loss Sharing Agreements Equal division of partnership income is required in the absence of a profit and loss sharing agreement.

Service Considerations in Profit and Loss Sharing Agreements A partner who devotes time to the partnership business while other partners work elsewhere may receive a salary allowance. Salary allowances are also used to compensate for differences in the fair value of the talents of partners.

Salary Allowance in Profit Sharing Agreements Bob, Gary, and Pete are partners. The partnership agreement provides that Bob and Gary receive salary allowances of $12,000 each, with the remaining income allocated equally. Partnership net income is $60,000 for 2003 and $12,000 for 2004.

Income Allocation Schedule: 2003 Bob Gary Pete Net income $60,000 Salary allowances to Bob and Gary (24,000) $12,000 $12,000 Remainder to divide 36,000 Divided equally (36,000) 12,000 12,000 $12,000 Remainder to divide 0 Net income allocation $24,000 $24,000 $12,000

Income Allocation Schedule: 2004 Bob Gary Pete Net income $12,000 Salary allowances to Bob and Gary (24,000) $12,000 $12,000 Remainder to divide (12,000) Divided equally 12,000 (4,000) (4,000) $(4,000) Remainder to divide 0 Net income allocation $ 8,000 $ 8,000 $(4,000)

Journal Entries December 31, 2003 Revenue and Expense Summary 60,000 Bob, Capital 24,000 Gary, Capital 24,000 Pete, Capital 12,000 Partnership income allocation for 2003

Journal Entries December 31, 2004 Revenue and Expense Summary 12,000 Pete, Capital 4,000 Bob, Capital 8,000 Gary, Capital 8,000 Partnership income allocation for 2004

Bonus and Salary Allowances The partnership agreement provides that Bob receive a bonus of 10% of partnership net income. Bob and Gary receive salary allowances of $10,000 and $8,000, respectively, and the remaining income is allocated equally. Partnership net income is $60,000 for 2003 and $12,000 for 2004.

Income Allocation Schedule: 2003 Bob Gary Pete Net income $60,000 Bonus to Bob (6,000) $ 6,000 Remainder to divide 54,000 Salary allowances to Bob and Gary (18,000) 10,000 $ 8,000 Remainder to divide 36,000 Divided equally (36,000) 12,000 12,000 $12,000 Remainder to divide 0 Net income allocation $28,000 $20,000 $12,000

Income Allocation Schedule: 2004 Bob Gary Pete Net income $12,000 Bonus to Bob (1,200) $ 1,200 Remainder to divide 10,800 Salary allowances to Bob and Gary (18,000) 10,000 $8,000 Remainder to divide (7,200) Divided equally 7,200 (2,400) (2,400) $(2,400) Remainder to divide 0 Net income allocation $ 8,800 $5,600 $(2,400)

Income Allocated in Relation to Partnership Capital Capital balances 1/1/2003 $20,000 $20,000 Investment April 1 2,000 — Withdrawal July 1 — (5,000) Investment September 1 3,000 — Withdrawal October 1 — (4,000) Investment December 28 — 8,000 Capital balances 12/31/2003 $25,000 $19,000 Ace Butch

Comparison of Capital Bases Weighted Beginning Ending Average Capital Capital Capital Investment Investment Investment Ace $20,000 $25,000 $22,500 Butch 20,000 19,000 16,500 Total $40,000 $44,000 $39,000

Alternatives Net income of $100,000 is divided on the basis of capital balances. Beginning Capital Balances Ace ($100,000 × 20/40) $ 50,000 Butch ($100,000 × 20/40) 50,000 Total income $100,000

Alternatives Ending Capital Balances Ace ($100,000 × 25/44) $ 56,818.18 Butch ($100,000 × 19/44) 43,181.82 Total income $100,000.00 Average Capital Balances Ace ($100,000 × 22.5/39) $ 57,692.31 Butch ($100,000 × 16.5/39) 42,307.69 Total income $100,000.00

Interest Allowances on Partnership Capital An agreement may provide for interest allowances on partnership capital in order to encourage capital investments, as well as salary allowances. Remaining profits are then divided equally or in any other ratio specified in the profit sharing agreement.

Value new partners’ investment in an existing partnership. Learning Objective 4 Value new partners’ investment in an existing partnership.

Changes in Partnership Interest The existing legal partnership entity is dissolved when a new partner is admitted or an existing partner retires or dies.

Changes in Partnership Interest Assignment of an interest to a third party Admission of a new partner Purchase of an interest from existing partners Investing in an existing partnership

Value partner’s share upon Learning Objective 5 Value partner’s share upon retirement or death.

Dissolution of a Continuing Partnership Through Death or Retirement Profit and Capital Percentage Loss Balances of Capital Percentage Bonnie $ 70,000 35% 40% Clyde 50,000 25 20 Dillinger 80,000 40 40 Total capital $200,000 100% 100%

Dissolution of a Continuing Partnership Through Death or Retirement Dillinger decides to retire. The partners agree that the business is undervalued on the partnership books and that Dillinger will be paid $92,000.

Bonus to Retiring Partner Dillinger, Capital 80,000 Bonnie, Capital 8,000 Clyde, Capital 4,000 Cash 92,000 Dillinger, Capital 80,000 Goodwill 12,000 Cash 92,000

Reevaluation of Total Partnership Capital Goodwill (other assets) 30,000 Bonnie, Capital 12,000 Clyde, Capital 6,000 Dillinger, Capital 12,000

Payment to Retiring Partner Less than Capital Balance Suppose that Dillinger is paid $72,000 in final settlement of his capital interest.

Overvalued Assets Written Down Bonnie, Capital 8,000 Clyde, Capital 4,000 Dillinger, Capital 8,000 Net assets 20,000 Dillinger, Capital 72,000 Cash 72,000

Bonus to Continuing Partners Dillinger, Capital 80,000 Bonnie, Capital 5,333 Clyde, Capital 2,667 Cash 72,000

Understand limited liability partnership characteristics. Learning Objective 6 Understand limited liability partnership characteristics.

Limited Partnerships The limited partnership consists of at least one general partner and one or more limited partners. The limited partner is excluded from the management of the business.

End of Chapter 15