Advanced Accounting by Debra Jeter and Paul Chaney Chapter 15: Partnerships: Formation, Operation, and Ownership Changes Slides Authored by Hannah Wong, Ph.D. Rutgers University

Partnership Definition Attributes An association of two or more persons to carry on as co-owners of a business for profit Attributes an agreement the business operates for profit members of the firm must be co-owners obj 1

General Partnership All partners are general partners Mutual agency Right to dispose of a partnership interest Unlimited liability Limited or uncertain life Tax implications: partnership income is allocated to partners who are taxed on their individual tax returns (form 1040) obj 1

Limited Partnership At least one general partner and one limited partner General partner: manage the firm unlimited liability Limited partner: invest capital only limited liability obj 1

Joint Venture An agreement by two or more parties to accomplish a limited purpose for their mutual benefit, often to earn a profit. Each joint venturer participates directly or indirectly in the management of the resources obj 1

Partnership Agreement name of the firm, identity of the partners nature, purpose and scope of business date of organization length of operating time location of business allocation of profit and loss salaries and withdrawals of assets by partners rights, duties and obligations of each partner contractual authority of each partner obj 2

Partnership Agreement procedure for admitting a new partner plan on withdrawal or death of a partner procedures for arbitration of disputes fiscal period identification and valuation of initial asset investments situations for dissolution of partnership accounting practices whether an audit is to be performed obj 2

Financial Statement Presentation Difference between partnership and corporation reporting: changes in partners’ equity during the year should be disclosed partners’ salary allowances is not an expense no income tax expense interest on capital investment is not an expense. obj 3

Capital vs. Drawing Accounts Capital Account – Reflects permanent investment of partner periodically updated for withdrawals. Drawing Account – Used to record withdrawals during the year. Closed to capital account at end of year. obj 4

Fair value of assets invested Bonus Method MV of asset investment = negotiated capital interest Assets contributed by Wright $40,000 Wright, capital $45,000 Fair value of assets invested $90,000 Assets contributed by Young $50,000 Young, capital $45,000 obj 5

Goodwill Method MV of asset investment = negotiated capital interest Goodwill of $10,000 is recorded Wright, capital $50,000 Assets contributed by Wright $40,000 $90,000 Fair value of assets invested Assets contributed by Young $50,000 Young, capital $50,000 obj 5

Profit/Loss Allocation Fixed Ratio Profit $20,000 7:3 Adams $14,000 Brown $6,000 obj 6

Profit/Loss Allocation Capital Balances 7:3 Adams Capital $60,000 Brown Capital $40,000 = 3:2 Profit $20,000 3:2 Adams $14,000 Brown $6,000 obj 6

Profit/Loss Allocation Interest Allocation Steps: (1) Allocate profit as interest on capital investment (2) allocate the remaining income on another basis obj 6

Profit/Loss Allocation Interest Allocation The following should be specified: the interest rate capital balance to be used how remaining profit should be allocated whether or not interest should be allocated if profit < agreed interest allocation obj 6

Profit/Loss Allocation Interest Allocation Profit $20,000 Interest allocation Unallocated profit Adams $6,200 7:3 Brown $3,000 Allocation of remaining profit Interest allocated = capital balance x interest rate Brown $5,400 Adams $5,400 1:1 obj 6

Profit/Loss Allocation Salary and Bonus Allocation Allocate profit as: fixed salary or provide for a bonus as a % of net income The net income used in bonus calculation can be before allocation of income to partners after other allocations, but before the bonus after bonus, but before other allocations after bonus and all other allocations obj 6

Insufficient Income to Cover Allocation If partnership income > interest and/or salary allocation allocate the deficiency in the agreed ratio for allocating residual income obj 6

Insufficient Income to Cover Allocation Profit $11,000 Salary allocation Interest allocation Deficiency in profit Adams $4,000 Brown $2,000 7:3 Adams $6,200 Brown $3,000 Brown ($2,100) Adams ($2,100) 1:1 obj 6

Pay salaries to partners reflective of time dedicated to partnership. Salary and Interest Partnerships pay salary and interest to effect an equitable distribution of income. Pay interest on initial investment as a return on investment. Compensates each partner for use of assets. Pay salaries to partners reflective of time dedicated to partnership. obj 7

Admission of New Partner A new partner can acquire an interest in a partnership by: purchasing an interest from an existing partner New partner acquires the right to share profits only no right to participate in management unless granted by all remaining partners investing assets obj 8

Assignment of Partnership Interest By Payment to Partners - Bonus Method Adams, Capital 18,000 Brown, Capital 12,000 Call, Capital 30,000 To transfer capital from capital accounts of Adams and Brown to Call’s capital account. Amounts = recorded capital x % interest acquired by Call obj 8

Assignment of Partnership Interest By Payment to Partners - Goodwill Method Goodwill 20,000 Adams, Capital 12,000 Brown, Capital 8,000 To record implied goodwill = Call’s payments / % interest acquired - recorded partnership net assets = $36000 / 30% -$100,000 Adams, Capital 18,000 Brown, Capital 12,000 Call, Capital 30,000 To transfer capital from capital accounts of Adams and Brown to Call’s capital account. obj 8

Asset Investment BV Acquired = Assets Invested Cash 35,000 Call, Capital 35,000 To record Call’s 1/3 capital in the partnership = (existing net assets + assets invested by Call) x 1/3 = ($70,000 + $35,000) x 1/3 = $35,000 obj 8

Asset Investment BV Acquired < Assets Invested : Bonus Method Cash 50,000 Call, Adams 6,000 Call, Brown 4,000 Call, Capital 40,000 The excess is considered a bonus to the existing partners To record Call’s 1/3 capital in the partnership = (existing net assets + assets invested by Call) x 1/3 = ($70,000 + $50,000) x 1/3 obj 8

Asset Investment BV Acquired < Assets Invested : Goodwill Method Adams, Capital 18,000 Brown, Capital 12,000 Implied total net assets = Call’s payments / % interest acquired = $50000 / 30% = $150,000 goodwill for existing partners = implied net assets x % ownership - current capital accounts = $150,000 x 2/3 - $70,000 = $30,000 obj 8

Asset Investment BV Acquired < Assets Invested : Goodwill Method Cash 50,000 Call, Capital 50,000 To record Call’s 1/3 capital in the partnership = (implied net assets) x 1/3 = $150,000x 1/3 obj 8

Payment to a Retiring Partner Payment > BV: Bonus Method Call, Adams 30,000 Call, Brown 6,000 Call, Capital 4,000 Liability to Adams 40,000 The excess is considered a bonus to the retiring partners; allocated to existing partners by their profit and loss ratio To record $40,000 agreed payment to Adams obj 8

Payment to a Retiring Partner Payment > BV: Goodwill Method Goodwill 20,000 Adams, Capital 10,000 Brown, Capital 6,000 Call, Capital 4,000 Implied goodwill = excess payment to Adams / % interest withdrawn = $10000 / 50% = $200,000 The goodwill is allocated to partners by their profit and loss ratio obj 8

Rational for Goodwill Method in Accounting for Partnership Membership Differences between historical cost and market value of assets Presence of intangible assets obj 9

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