15-15-11
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Partnerships: Formation, Operation, and Changes in Membership
15Electronic Presentation by
Douglas Cloud Pepperdine University
Baker / Lembke / KingBaker / Lembke / King
15-15-22
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
Definition of a PartnershipDefinition of a Partnership
15-15-33
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Definition of a PartnershipDefinition of a Partnership
The partnership must attempt to make a profit; therefore, not-for-profit organizations may
not be partnerships.
15-15-44
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
Articles of Copartnership Includes--Articles of Copartnership Includes--
ContinuedContinued
15-15-55
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
Articles of Copartnership Includes--Articles of Copartnership Includes--
15-15-66
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Articles of CopartnershipArticles of Copartnership
Each partner should sign the partnership
agreement to indicate acceptance
of the terms.
15-15-77
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
• 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.
Other Major Characteristics Other Major Characteristics
Also known Also known as as
“Dissolution “Dissolution of the of the
partnership”partnership”Any partner Any partner can bind the can bind the partnership if partnership if acting within acting within the scope of the scope of the partner-the partner-
ship.ship.
Limited Limited partners have partners have
limited limited liability.liability.
15-15-88
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Other Major Characteristics 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.
15-15-99
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Accounting for Partnership FormationAccounting for Partnership FormationAlt, a sole proprietor, has the following accounts as of December 31, 20X0:
Cash 3,000Inventory 7,000Equipment 20,000
Accumulated Depreciation-- Equipment 5,000Liabilities 10,000Alt, Capital 15,000
15-15-1010
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
Accounting for Partnership FormationAccounting for Partnership Formation
15-15-1111
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Accounting for Partnership FormationAccounting for Partnership Formation
January 1, 20X1Cash 13,000Inventory 9,000Equipment 19,000
Liabilities 11,000Alt, Capital 20,000Blue, Capital 10,000
Formation of AB Partnershipby capital contributions of Alt and Blue.
Fair Market Value
15-15-1212
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Accounting for Partnership OperationsAccounting 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.
ContinuedContinued
15-15-1313
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Accounting for Partnership OperationsAccounting 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.
15-15-1414
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Preselected ratio. Interest on capital
balances. Salaries to partners. Bonuses to partners.
Allocating Profit or Loss to PartnersAllocating Profit or Loss to Partners
15-15-1515
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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-
Illustrations of Profit AllocationIllustrations 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.
Profits shared 60%:40%
15-15-1616
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Blue, Capital 4,000Blue, Drawing 4,000
Close Blue’s drawing account.
During the year, Blue withdrew $4,000 from the business. A closing entry is needed to reflect this reduction in Blue, Capital.
Income Summary 10,000Alt, Capital 6,000Blue, Capital 4,000
Distribute profit in accordance withpartnership agreement.
Another entry is required to distribute the profit in accordance with the partnership agreement.
Illustrations of Profit AllocationIllustrations of Profit Allocation
15-15-1717
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Blue’s Weighted-Average Capital Balance
Average capital: $96,000 12 months = $8,000
Illustrations of Profit AllocationIllustrations of Profit Allocation
Interest on Capital Balances
Months Months Times Date Debit Credit Balance Maintained Dollar Balance
January 1 $10,000 4 $40,000May 1 $3,000 7,000 4 28,000September 1 $500 7,500 2 15,000November 1 1,000 6,500 2 13,000Total 12 $96,000
15-15-1818
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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 TotalProfit percentage 60% 40% 100% Average capital $20,000 $8,000Net 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-
Illustrations of Profit AllocationIllustrations of Profit Allocation
15-15-1919
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Illustrations of Profit AllocationIllustrations 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.
15-15-2020
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Alt Blue TotalProfit percentage 60% 40% 100% Net income $10,000 Salary $2,000 $5,000 (7,000)Residual income $ 3,000 Allocate 60:40 1,800 1,200 (3,000)Total $3,800 $6,200 $ -0-
Illustrations of Profit AllocationIllustrations of Profit Allocation
15-15-2121
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
BonusesBonuses
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.
Bonus = .10 (Net income - Minimum income)Bonus = .10 ($10,000 - $5,000)Bonus = $500
Case 1: The bonus is computed as a percentage of income before subtracting the bonus.
15-15-2222
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
BonusesBonuses
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.
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 = $500Bonus = $454.55
Case 2: The bonus is computed as a percentage of income after subtracting the bonus.
15-15-2323
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
BonusesBonuses
The distribution of net income based on Case 2 (bonus of $454.55) is calculated as follows:
Alt Blue TotalProfit percentage 60% 40% 100% Net income $10,000Bonus to partner (rounded) $ 455 (455)Residual income $ 9,545Allocation 60:40 $5,727 3,818 (9,545)Total $5,727 $4,273 $ -0-
15-15-2424
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Multiple Bases for Profit AllocationMultiple Bases for Profit Allocation
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 before subtracting 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.
AB Partnership agreement specifies the following:
15-15-2525
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Multiple Bases for Profit AllocationMultiple Bases for Profit Allocation Alt Blue Total
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-
60% 40% 100%
15-15-2626
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Partnership Financial StatementPartnership Financial Statement
AB PartnershipStatement of Partners’ Capital
For the Year Ended December 31, 20X1 Alt Blue Total
Balance, January 1, 20X1 $20,000 $10,000 $30,000Add: Additional investment 500 500
Net income distribution 3,980 6,020 10,000$23,980 $16,520 $40,500
Less: Withdrawal (4,000) (4,000)Balance, December 31, 20X1 $23,980 $12,520 36,500
15-15-2727
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes in MembershipChanges in Membership
Admission of a new partner
Withdrawal of a partner
15-15-2828
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Purchases an InterestNew 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) 5,000Blue, Capital ($10,000 x .25) 2,500
Cha, Capital 7,500Reclassifying capital to new partner.
15-15-2929
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Invests in PartnershipNew Partner Invests in Partnership
New partner’s
proportion of the
partnership’s book value
Prior capital of present partners
Investment of new partner
Percentage of capital
to new partner
+= x
15-15-3030
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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 10,000Cha, Capital ($40,000 x .25) 10,000
Admission of Cha for one-fourth interestupon investment of $10,000.
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 ValueNew Partner Invests Amount Equal to Book Value
15-15-3131
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
New Partner Invests More Than Book ValueNew Partner Invests More Than Book Value
Investment in partnership $11,000 New partner’s proportionate book value ($30,000 + $11,000) x .25 (10,250)Difference $ 750
15-15-3232
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Invests More Than Book ValueNew Partner Invests More Than Book Value
Three alternative accounting treatments exist in this case:
ContinuedContinued
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.
15-15-3333
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Invests More Than Book ValueNew Partner Invests More Than Book Value
Three alternative accounting treatments exist in this case:
ContinuedContinued
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.
15-15-3434
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Invests More Than Book ValueNew 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.
15-15-3535
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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 3,000Alt, Capital (60%) 1,800Blue, Capital (40%) 1,200
Revalue partnership land to market value.
New Partner Invests More Than Book ValueNew Partner Invests More Than Book Value
Cash 11,000Cha, Capital ($44,000 x .25) 11,000
Admission of Cha for one-fourth capitalin ABC Partnership.
Total resulting capital is $44,000.
15-15-3636
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Step 1:25% of estimated total resulting capital $11,000Estimated total resulting capital ($11,000 .25) $44,000
Step 2:Estimated total resulting capital $44,000Total net assets not including goodwill ($30,000 + $11,000) (41,000)Estimated goodwill to prior partners $ 3,000
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.
New Partner Invests More Than Book ValueNew Partner Invests More Than Book Value
15-15-3737
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
First, the unrecorded goodwill is recorded and the two original partners’ capital accounts are adjusted.
Goodwill 3,000Alt, Capital (60%) 1,800Blue, Capital (40%) 1,200
Recognize unrecorded goodwill.
Cash 11,000Cha, Capital ($44,000 x .25) 11,000
Admission of Cha to partnership for one-fourth capital interest.
Next, Cha’s investment is recorded.
New Partner Invests More Than Book ValueNew Partner Invests More Than Book Value
15-15-3838
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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 = $41,000Cha’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 11,000Alt, Capital ($750 x .60) 450Blue, Capital ($750 x .40) 300Cha, Capital 10,250
Admission of Cha with bonus to Alt andBlue.
New Partner Invests More Than Book ValueNew Partner Invests More Than Book Value
15-15-3939
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Invests Less Than Book ValueNew 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)
15-15-4040
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Invests Less Than Book ValueNew Partner Invests Less Than Book Value
Three alternative accounting approaches are:
ContinuedContinued
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.
15-15-4141
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Invests Less Than Book ValueNew Partner Invests Less Than Book Value
Three alternative accounting approaches are:
ContinuedContinued
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.
15-15-4242
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
New Partner Invests Less Than Book ValueNew 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.
15-15-4343
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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) 3,600Blue, Capital ($6,000 x .40) 2,400
Inventory 6,000Revalue inventory to market. .
New Partner Invests Less Than Book ValueNew Partner Invests Less Than Book Value
Cha’s investment of $8,000 is recorded.
Cash 8,000Cha, Capital 8,000
Admission of Cha to partnership. .
15-15-4444
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
New Partner Invests Less Than Book ValueNew Partner Invests Less Than Book Value
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
15-15-4545
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The entry to record the admission of Cha into the ABC Partnership is:
New Partner Invests Less Than Book ValueNew Partner Invests Less Than Book Value
Cash 8,000Goodwill 2,000
Cha, Capital 10,000Admission 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.
15-15-4646
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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 8,000Alt, Capital ($1,500 x .60) 900Blue, Capital ($1,500 x .40) 600
Cha, Capital 9,500
Admission of Cha to partnership.
New Partner Invests Less Than Book ValueNew Partner Invests Less Than Book Value
The capital credit assigned to the new partners is her share of the total resulting capital ($30,000 + $8,000) x .25.
15-15-4747
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
Retirement of a Partner from PartnershipRetirement of a Partner from Partnership
May account for using:
15-15-4848
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter FifteenChapter Fifteen
The The EndEnd