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Partnerships: Formation, Operation, and Changes in Membership

Baker / Lembke / King. Partnerships: Formation, Operation, and Changes in Membership. 15. Electronic Presentation by Douglas Cloud Pepperdine University. Definition of a Partnership.

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Partnerships: Formation, Operation, and Changes in Membership

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  1. Baker / Lembke / King Partnerships: Formation, Operation, and Changes in Membership 15 Electronic Presentation by Douglas Cloud Pepperdine University

  2. Definition of a Partnership • Association of two or more persons. The “persons” are usually individuals; however, they could be corporations or other partnerships. • To carry on as co-owners. A partnership is an aggregation of partners’ individual rights. • Business for profit. A partnership may be formed to perform any legal business, trade, profession, or other service.

  3. Definition of a Partnership The partnership must attempt to make a profit; therefore, not-for-profit organizations may not be partnerships.

  4. Articles of Copartnership Includes-- • The name of the partnership and the names of the partners. • The type of business to be conducted by the partnership and the duration of the partnership agreement. • The initial capital contribution of each partner and the method by which future capital contributions are to be accounted for. Continued

  5. Articles of Copartnership Includes-- • A complete specification of the profit or loss distribution, including salaries, interest on capital balances, bonuses, limits on withdrawals, and distribution percentage. • Procedures used for changes in the partnership and a retirement of a partner. • Other aspects of operating the partners decide on, such as the management rights of each partners, election procedures, and accounting methods.

  6. Articles of Copartnership Each partner should sign the partnership agreement to indicate acceptance of the terms.

  7. Other Major Characteristics Also known as “Dissolution of the partnership” • Limited life. A partnership legally terminates as a business entity each time there is a change in membership. • Agency relationship. Each partner is a co-owner of the partnership assets and liabilities. • Unlimited liability. All partners in a general partnership have unlimited liability. Any partner can bind the partnership if acting within the scope of the partner-ship. Limited partners have limited liability.

  8. Other Major Characteristics Limited Liability Partnership The partners are not personally liability for any debt, obligation, or liability that is chargeable to the partnership. The partners are still liable up to the amount of their capital accounts. A limited liability partnership must identify itself by adding the letters LLP behind the name of the partnership.

  9. Accounting for Partnership Formation Alt, a sole proprietor, has the following accounts as of December 31, 20X0: Cash 3,000 Inventory 7,000 Equipment 20,000 Accumulated Depreciation-- Equipment 5,000 Liabilities 10,000 Alt, Capital 15,000

  10. Accounting for Partnership Formation Blue offers to invest $10,000 in the a partnership interest in the business. As part of forming the partnership, Alt’s business is audited and an appraisal discloses that $1,000 of the liabilities have not been recorded, inventory has a market value of $9,000, and the equipment has a fair value of $19,000.

  11. Accounting for Partnership Formation Fair Market Value January 1, 20X1 Cash 13,000 Inventory 9,000 Equipment 19,000 Liabilities 11,000 Alt, Capital 20,000 Blue, Capital 10,000 Formation of AB Partnership by capital contributions of Alt and Blue.

  12. Accounting for Partnership Operations Capital Accounts. This account eventually contains the initial investment by each partner, any subsequent capital contributions, profit or loss distributions, and any withdrawals of capital by the partners. Drawing Accounts. A separate drawing account often is used to record the periodic withdrawals by each partner. Each drawing account is closed to the partner’s capital account at the end of the fiscal period. Continued

  13. Accounting for Partnership Operations Loan Accounts. Any loans between a partner and the partnership should always be accompanied by proper loan documentation such as a promissory note. Unless agreed by all partners, the partnership is obligated to pay interest on the loan to the individual partners.

  14. Allocating Profit or Loss to Partners • Preselected ratio. • Interest on capital balances. • Salaries to partners. • Bonuses to partners.

  15. Illustrations of Profit Allocation During 20X1, the AB Partnership earns a profit of $10,000 for the year. Alt maintains a capital balance of $20,000 during the year, but Blue’s capital investment fluctuates between $6,500 and $10,000. Alt Blue Total Profit sharing percentage 60% 40% 100% Net income $10,000 Allocate 60:40 $6,000 $4,000 (10,000) Total $6,000 $4,000 $ -0- Profits shared 60%:40%

  16. Illustrations of Profit Allocation During the year, Blue withdrew $4,000 from the business. A closing entry is needed to reflect this reduction in Blue, Capital. Blue, Capital 4,000 Blue, Drawing 4,000 Close Blue’s drawing account. Another entry is required to distribute the profit in accordance with the partnership agreement. Income Summary 10,000 Alt, Capital 6,000 Blue, Capital 4,000 Distribute profit in accordance with partnership agreement.

  17. Illustrations of Profit Allocation Months Months Times Date Debit Credit Balance Maintained Dollar Balance January 1 $10,000 4 $40,000 May 1 $3,000 7,000 4 28,000 September 1 $500 7,500 2 15,000 November 1 1,000 6,500 213,000 Total 12 $96,000 Interest on Capital Balances Blue’s Weighted-Average Capital Balance Average capital: $96,000  12 months = $8,000

  18. Illustrations of Profit Allocation Alt and Blue agreed to allow interest of 15 percent on the weighted-average capital balances with any remaining profit to be distributed 60:40 percent. Alt Blue Total Profit percentage 60% 40% 100% Average capital $20,000 $8,000 Net income $10,000 Interest on average capital $ 3,000 $1,200 (4,200) Residual income $ 5,800 Allocate 60:40 $ 3,480 $2,320 (5,800) Total $ 6,480 $3,520 $ -0-

  19. Illustrations of Profit Allocation The partnership agreement between Alt and Blue provides for salaries of $2,000 for Alt and $5,000 for Blue. Any remainder is to be distributed in the profit and loss sharing ratio of 60:40 percent.

  20. Illustrations of Profit Allocation Alt Blue Total Profit percentage 60% 40% 100% Net income $10,000 Salary $2,000 $5,000 (7,000) Residual income $ 3,000 Allocate 60:40 1,8001,200 (3,000) Total $3,800 $6,200 $ -0-

  21. Bonuses A bonus of 10 percent of income in excess of $5,000 is to be credited to Blue’s capital account before distributing remaining profit. Case 1: The bonus is computed as a percentage of income before subtracting the bonus. Bonus = .10 (Net income - Minimum income) Bonus = .10 ($10,000 - $5,000) Bonus = $500

  22. Bonuses A bonus of 10 percent of income in excess of $5,000 is to be credited to Blue’s capital account before distributing remaining profit. Case 2: The bonus is computed as a percentage of income after subtracting the bonus. Bonus = .10 (Net income - Minimum income -Bonus) Bonus = .10 ($10,000 - $5,000 - Bonus) Bonus = .10 ($5,000 - Bonus) Bonus = $500 - .10 Bonus 1.10 Bonus = $500 Bonus = $454.55

  23. Bonuses The distribution of net income based on Case 2 (bonus of $454.55) is calculated as follows: Alt Blue Total Profit percentage 60% 40% 100% Net income $10,000 Bonus to partner (rounded) $ 455 (455) Residual income $ 9,545 Allocation 60:40 $5,7273,818(9,545) Total $5,727 $4,273 $ -0-

  24. Multiple Bases for Profit Allocation AB Partnership agreement specifies the following: 1. Interest of 15 percent on weighted-average capital balances. 2. Salaries of $2,000 for Alt and $5,000 for Blue. 3. A bonus of 10 percent to be paid to Blue on partnership income exceeding $5,000 beforesubtracting the bonus, partners’ salaries, and interest on capital balances. 4. Any residual to be allocated in the ratio of 60 percent to Alt and 40 percent to Blue.

  25. Multiple Bases for Profit Allocation Alt Blue Total 60% 40% 100% Profit percentage Average capital $20,000 $8,000 Net income $10,000 Step 1: Interest on average capital $ 3,000 $1,200 (4,200) Remaining after step 1 $ 5,800 Step 2: Salary 2,000 5,000 (7,000) Deficiency after step 2 $(1,200) Step 3: Bonus 500 (500) Deficiency after step 3 $(1,700) Step 4: Allocate 60:40 (1,020) (680) 1,700 Total $3,980 $6,020 $ -0-

  26. Partnership Financial Statement AB Partnership Statement of Partners’ Capital For the Year Ended December 31, 20X1 Alt Blue Total Balance, January 1, 20X1 $20,000 $10,000 $30,000 Add: Additional investment 500 500 Net income distribution 3,980 6,02010,000 $23,980 $16,520 $40,500 Less: Withdrawal (4,000) (4,000) Balance, December 31, 20X1 $23,980 $12,520 36,500

  27. Changes in Membership Withdrawal of a partner Admission of a new partner

  28. New Partner Purchases an Interest On January 1, 20X3, Alt and Blue invite Cha to become a partner in their business. Cha purchases a one-fourth interest in the partnership capital directly from Alt and Blue by paying $5,900 to Alt and $3,100 to Blue. Cha will have a capital credit of $7,500 (.25 x total capital, $30,000). Cha will be entitled to 25 percent interest in the profits or losses of the partnership. The remaining 75 percent interest will be divided between Alt and Blue in their old profit ratio of 60:40. Alt, Capital($20,000 x .25) 5,000 Blue, Capital ($10,000 x .25) 2,500 Cha, Capital 7,500 Reclassifying capital to new partner.

  29. New Partner Invests in Partnership New partner’s proportion of the partnership’s book value Percentage of capital to new partner Prior capital of present partners Investment of new partner x + =

  30. Investment in partnership $10,000 New partner’s proportionate book value ($30,000 + $10,000) x .25 (10,000) Difference $ -0- New Partner Invests Amount Equal to Book Value Case 1: The total book value of the partnership before the admission of Cha is $30,000. Cha buys one-fourth interest for $10,000. Cash 10,000 Cha, Capital ($40,000 x .25) 10,000 Admission of Cha for one-fourth interest upon investment of $10,000.

  31. Investment in partnership $11,000 New partner’s proportionate book value ($30,000 + $11,000) x .25 (10,250) Difference $ 750 New Partner Invests More Than Book Value Case 2: The total book value of the partnership before the admission of Cha is $30,000. Cha buys one-fourth interest for $11,000.

  32. New Partner Invests More Than Book Value Three alternative accounting treatments exist in this case: 1. Revalue assets upward.Under this alternative: a. Asset book values are increased to their market values. b. The prior partners’ capital accounts are increased for their respective shares of the increase in the book values of the assets. c. Total resulting capital of the partnership is the prior capital balances plus the amount of asset revaluation plus the new partner’s investment. Continued

  33. New Partner Invests More Than Book Value Three alternative accounting treatments exist in this case: 2. Record unrecognized goodwill.With this method: a. Unrecognized goodwill is recorded. b. The prior partners’ capital accounts are increased for their respective shares of the goodwill. c. Total resulting capital of the partnership is the prior capital balances plus the goodwill recognized plus the new partner’s investment. Continued

  34. New Partner Invests More Than Book Value Three alternative accounting treatments exist in this case: 3. Use bonus method .Essentially, the bonus method is a transfer of capital balances among the partners. This method is used when the partners do not wish to record adjustments in asset accounts and do not want to recognize goodwill. Under this method: a. The prior partners’ capital accounts are increased for their respective shares of the bonus paid by the new partner. b. Total resulting capital of the partnership is the prior capital balances plus the new partner’s investment.

  35. New Partner Invests More Than Book Value Case 2: Revaluation of assets. Cha was willing to pay more than one-fourth the book value because the partnership’s land was undervalued by $3,000. This increase in value is allocated to the two original partners in a 60:40 ratio. Land 3,000 Alt, Capital (60%) 1,800 Blue, Capital (40%) 1,200 Revalue partnership land to market value. Cash 11,000 Cha, Capital ($44,000 x .25) 11,000 Admission of Cha for one-fourth capital in ABC Partnership. Total resulting capital is $44,000.

  36. New Partner Invests More Than Book Value Case 2 (continued): Goodwill recognition. If Cha invests $11,000 for one-fourth interest, she must feel that the resulting partnership’s capital is $44,000. Step 1: 25% of estimated total resulting capital $11,000 Estimated total resulting capital ($11,000  .25) $44,000 Step 2: Estimated total resulting capital $44,000 Total net assets not including goodwill ($30,000 + $11,000) (41,000) Estimated goodwill to prior partners $ 3,000

  37. New Partner Invests More Than Book Value First, the unrecorded goodwill is recorded and the two original partners’ capital accounts are adjusted. Goodwill 3,000 Alt, Capital (60%) 1,800 Blue, Capital (40%) 1,200 Recognize unrecorded goodwill. Next, Cha’s investment is recorded. Cash 11,000 Cha, Capital ($44,000 x .25) 11,000 Admission of Cha to partnership for one- fourth capital interest.

  38. New Partner Invests More Than Book Value Case 2 (continued): The bonus method.The bonus method avoids reevaluating assets and recognizing goodwill. First, the new total capital is determined: $30,000 + $11,000 = $41,000 Cha’s proportion of the resulting capital is 25 percent or $10,250 ($41,000 ÷ 4). The remaining $750 is divided between the original partners 60:40. Cash 11,000 Alt, Capital ($750 x .60) 450 Blue, Capital ($750 x .40) 300 Cha, Capital 10,250 Admission of Cha with bonus to Alt and Blue.

  39. New Partner Invests Less Than Book Value Case 3: Cha invests $8,000 for a one-fourth capital interest in the ABC Partnership. Investment in partnership $ 8,000 New partner’s proportionate book value ($30,000 + $11,000) x .25 (9,500) Difference (investment< book value) $(1,500)

  40. New Partner Invests Less Than Book Value Three alternative accounting approaches are: 1. Revalue assets downward.Under this alternative: a. Asset book values are decreased to recognize the reduction in their values. b. The prior partners’ capital accounts are decreased for their respective shares of the decrease in the book values of the assets. c. Total resulting capital of the partnership is the prior capital balances less the amount of asset valuation write-down plus the new partner’s investment. Continued

  41. New Partner Invests Less Than Book Value Three alternative accounting approaches are: 2. Recognize goodwill brought in by the new partner.In this approach: a. Goodwill or other intangible benefits brought in by the new partner are recorded and also included in the new partners’ capital account. b. The prior partners’ capital accounts remain unchanged. c. Total resulting capital of the partnership is the prior capital balances plus the new goodwill brought in plus the new partner’s tangible investment. Continued

  42. New Partner Invests Less Than Book Value Three alternative accounting approaches are: 3. Use bonus method . Under the bonus method: a. The new partner is assigned a bonus from the prior partners’ capital accounts, which are decreased for their respective shares of the bonus paid to the new partner. b. Total resulting capital of the partnership is the prior capital balances plus the new partner’s investment.

  43. New Partner Invests Less Than Book Value Case 3: Revaluation of Assets. Alt and Blue agree to accept Cha to a one-fourth interest for an $8,000 investment. The original partners agree to write down the inventory to its fair value before admission of Cha. Alt, Capital ($6,000 x .60)3,600 Blue, Capital ($6,000 x .40) 2,400 Inventory6,000 Revalue inventory to market. . Cha’s investment of $8,000 is recorded. Cash8,000 Cha, Capital 8,000 Admission of Cha to partnership. .

  44. New Partner Invests Less Than Book Value Case 3 (continued): Recognize goodwill. Alt and Blue agree to accept Cha to a one-fourth interest for an $8,000 investment. Alt, Blue, and Cha agree that Cha’s abilities will generate excess earnings for the resulting ABC Partnership. Step 1: 75% of estimated total resulting capital $30,000 Estimated total resulting capital ($30,000  .75) $40,000 Step 2: Estimated total resulting capital $40,000 Total net assets not including goodwill ($30,000 + $8,000) (38,000) Estimated goodwill $ 2,000

  45. New Partner Invests Less Than Book Value The entry to record the admission of Cha into the ABC Partnership is: Cash 8,000 Goodwill 2,000 Cha, Capital10,000 Admission of Cha to partnership. The total resulting capital of the ABC Partnership is now $40,000, with Alt and Blue together having a 75 percent interest and Cha having a 25 percent interest.

  46. New Partner Invests Less Than Book Value Case 3 (continued): Bonus to new partner. Alt and Blue agree to accept Cha to a one-fourth interest for an $8,000 investment. The original partners’ capital accounts are reduced by $1,500 in their profit and loss ratio. Cash 8,000 Alt, Capital ($1,500 x .60)900 Blue, Capital ($1,500 x .40) 600 Cha, Capital 9,500 Admission of Cha to partnership. The capital credit assigned to the new partners is her share of the total resulting capital ($30,000 + $8,000) x .25.

  47. Retirement of a Partner from Partnership May account for using: • Bonus to retiring partner. • Asset revaluation and then payment to retiring partner. • Goodwill to retiring partner: • Only recognize retiring partner’s share of goodwill. • Recognize all goodwill.

  48. Chapter Fifteen The End

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