partnerships: formation, operation, and changes in membership

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 15Chapter 15

Partnerships: Formation, Partnerships: Formation, Operation, and Changes in Operation, and Changes in

MembershipMembership

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Understand and explain the nature and regulation of

partnerships.

Learning Objective 1Learning Objective 1

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What is a Partnership?What is a Partnership?

An association of two or more persons who are co-owners of a

business, and share profits and losses

in an agreed-upon manner. ABC

Company

A B

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What is a “Person”?What is a “Person”?

An individual A corporation Another partnership

Z CorpT&D

Partnership

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Partnerships: Pros & ConsPartnerships: Pros & Cons

Advantages Ease of formation Lack of formality Single taxation (see following slide)

Disadvantages Unlimited liability (for general partnerships) Difficulty in disposing of partnership interests Mutual agency

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Partnership Form of Organization: Income Tax Partnership Form of Organization: Income Tax ReportingReporting

Single Taxation of Partnership Earnings

Partnerships only report their earnings—they are not taxed at the business entity level (as are corporations).

Partnerships file IRS Form 1065, which shows the allocation of profits among partners.

Partners report their share of profits on their individual IRS Form 1040 return.

ABPartnership

A B

Uncle Sam

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RegulationRegulation

Each state regulates the partnerships that are formed in it.

Most states begin with a model act and then modifies it to fit that state’s business culture and history.

Most have now adopted the Uniform Partnership Act of 1997 (UPA 1997) as their model act.

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Regulation: The Uniform Partnership Act (UPA)Regulation: The Uniform Partnership Act (UPA)

The UPA 1997 covers: Relations of partners to one another. Relations of partners to persons dealing

with the partnership. Dissolution and winding up of the

partnership.

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The Partnership AgreementThe Partnership Agreement

What is a partnership agreement?

A written expression of what the partners have agreed to.

Examples of areas addressed: Manner of sharing profits. Limitations on withdrawals. Rights of partners. Settling with withdrawing partners. Expulsion of partners. Conflicts of interest.

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Practice Quiz Question #1Practice Quiz Question #1

Which of the following is not one of the advantages of general partnerships?

a. Ease of formationb. Unlimited liabilityc. Lack of formalityd. Single taxation



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Practice Quiz Question #1 Practice Quiz Question #1 SolutionSolution





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Understand and explain the differences among different

types of partnerships.

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Types of PartnershipsTypes of Partnerships

General Partnerships All partners have unlimited liability. Creditors can go after the personal assets of

any or all of the partners.

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Limited Partnerships Limited partners have limited liability to

partnership creditors if the partnership is unable to pay its debts. Limited partners’ risk is limited to their invested

capital. Thus, personal assets are not at risk.

At least one of the partners must be a general partner.

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Limited Liability Partnerships (LLPs) A partner’s personal assets are at risk only for

his or her own negligence and wrongdoing, the negligence and wrongdoing of those under his or

her control, but

not debts.

Since 1993, many accounting firms have changed from general partnerships to LLPs.

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Limited Liability Limited Partnerships (LLLPs) Like a limited partnership, must have at least one

general partner. General partners manage the partnership. Big difference relates to the liability of general

partners: No personal liability for partnership obligations (like a

limited partner)

Not liable for wrongdoing of other partners—just personal decisions and decisions of those supervised

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Which of the following statements is true?a.The partners in a general partnership have limited liability.b.At least two of the partners in a limited partnership must be general partners.c.Partners in an LLP are not responsible for their own actions.d.Limited liability limited partnerships must have at least one general partner.


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15-19


Make calculations and journal entries for the formation of

partnerships.

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Partners’ AccountsPartners’ Accounts

Each partner can have a capital account. a drawing account (a contra capital

account—closed out at year-end). a loan account (loans usually earn

interest—a partnership expense).

Partnerships do NOT use a retained earnings account. DR CR

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Recording Capital ContributionsRecording Capital Contributions

Keep it FAIR! Current Fair Market

Values should be used to record

noncash assets contributed to a partnership.

liabilities assumed by a partnership. ABC

Partnership

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$150,000 + $175,000 = $325,000

Partnership Formation ExamplePartnership Formation Example

Brian and Spencer wish to form the B&S partnership. Brian contributes land with a book value of $65,000 and a current value of $150,000 and a building with a book value of $142,000 and a current value of $175,000. Spencer will contribute cash.

If the partners plan to share profits and losses equally after the formation of the partnership and assuming they have agreed to equal capital contributions, how much cash will Spencer have to contribute to form the partnership?

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Comprehensive Partnership CreationComprehensive Partnership CreationGroup ProblemGroup Problem

The partnerships of Brad & Mike (B&M) and Austin and Justin (A&J) began business on 1/1/X1; each partnership owns one retail appliance store. The two partnerships agree to combine as of 7/1/X8 to form a new partnership, BAM-J Discount Stores.

REQUIRED: Given the information on the next two slides,1.Prepare the journal entries to record the initial capital contribution after considering the effect of this information. Use separate entries for each of the combining partnerships.2.Prepare a schedule computing the cash contributed or withdrawn by each partner to bring the initial capital balances into the profit and loss sharing ratio.

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1. Profit and loss ratios. The profit and loss sharing ratios for the former partnerships were 40% to Brad and 60% to Mike, and 30% to Austin and 70% to Justin. The profit and loss sharing ratio for the new partnership is Brad, 20%; Mike, 30%; Austin, 15%; and Justin, 35%.

2. Capital investments. The opening capital investments for the new partnership are to be in the same ratio as the profit and loss sharing ratios for the new partnership. If necessary, certain partners may have to contribute additional cash, and others may have to withdraw cash to bring the capital investments into the proper ratio.

3. Accounts receivable. The partners agreed to set the new partnership’s allowance for bad debts at 3% of the accounts receivable contributed by B&M and 12% of the accounts receivable contributed by A&J.

4. Inventory. The new partnership’s opening inventory is to be valued by the FIFO method. B&M used the FIFO method to value inventory (which approximates its current value), and A&J used the LIFO method. The LIFO inventory represents 85% of its FIFO value.

5. Property and equipment. The partners agree that the building’s current value is approximately 70% of the building’s historical cost, as recorded on each partnership’s books.

6. Unpaid liability. After each partnership’s books were closed on 6/30/X8, an unrecorded merchandise purchase of $1,500 by A&J was discovered. The merchandise had been sold by 6/30/X8.

7. The 6/30/X8 postclosing trial balances of the partnerships follow:

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Brad & Mike Trial Balance – June 30, 20X8

Austin & Justin Trial Balance – June 30, 20X8

Cash 25,000 22,000 Accounts Receivable 100,000 150,000

Allowance for doubtful accounts 2,000 6,000 Inventory 175,000 119,000

Building & Equipment 105,000 160,000 Accumulated Depreciation 24,000 61,000

Accounts Payable 40,000 60,000 Notes Payable 100,000 120,000 Brad, Capital 95,000 Mike, Capital 144,000

Austin, Capital 65,000 Justin, Capital 139,000

Totals 405,000 405,000 451,000 451,000

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Comprehensive Group Problem Comprehensive Group Problem Solution Solution

PART 1Summary of changes to carrying values:

Brad & Mike Austin & Justin

Increase allowance for bad debt $(1,000) $(12,000)

Increase inventory 21,000)

Increase buildings and equipment (7,500) 13,000)

Increase accounts payable (1,500)

Net increase $(8,500) $20,500)

Brad (40%) $(3,400) Austin (30%) $6,150

Mike (60%) (5,100) Justin (70%) 14,350

$(8,500) $20,500

Allocate to:

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Cash 25,000

Accounts Receivable 100,000

Allowance for doubtful accounts 3,000

Inventory 75,000

Building & Equipment 73,500

Accounts Payable 40,000

Notes Payable 100,000

Brad, Capital 91,600

Mike, Capital 138,900


Brad & Mike Journal Entry:

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Austin & Justin Journal Entry:

Cash 22,000

Accounts Receivable 150,000

Allowance for doubtful accounts 18,000

Inventory 140,000

Building & Equipment 112,000

Accounts Payable 61,500

Notes Payable 120,000

Austin, Capital 71,150

Justin, Capital 153,350

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PART 2

Brad Mike Austin Justin Total

Profit sharing percentage 20% 30% 15% 35%

Capital balances 91,600 138,900 71,150 153,350 455,000

Capital balances required using profit and loss sharing percentages

91,000 136,500 68,250 159,250

Capital contribution or (withdrawal)

(600) (2,400) (2,900) 5,900

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Make calculations and journal entries for the operation of

partnerships.

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Accounting for Operations of a PartnershipAccounting for Operations of a Partnership

Partners’ accounts Capital accounts

Used to record the initial investment of a partner, any subsequent capital contributions, profit or loss distributions, and any withdrawals of capital by the partner

Deficiencies are usually eliminated by additional capital contributions

CapitalInvestmentContributions

% Profit% Loss

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Accounting for Operations of a PartnershipAccounting for Operations of a Partnership

Partners’ accounts Drawing accounts

Used to record periodic withdrawals and is then closed to the partner’s capital account at the end of the period

Noncash drawings are valued at their market values at the date of the withdrawal

Loan accounts A loan from a partner is shown as a payable on the

partnership’s books Unless all partners agree otherwise, the partnership

is obligated to pay interest on the loan

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Which of the following would result in a reduction to a partner’s capital account?

a. The initial investment.b. The allocation of a profit.c. Additional capital contributions.d. A withdrawal.e. A loan to a partner.



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15-35


Make calculations and journal entries for the allocation of partnership profit or loss.

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Profit & Loss Summary 162,000Capital, Brian 81,000Capital, Spencer 81,000

Income Allocation ExampleIncome Allocation Example

Assume that in its first year of operation, B&S partnership earns $162,000 of income. What journal entry would B&S make to allocate the profits between the two partners?

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Sharing Profits and LossesSharing Profits and Losses

Partners can share profits and losses in any way they choose.

Possible ways include ratios. salary allowances and ratios. imputed interest on capital, salary

allowances, and ratios. capital balances only. performance methods.

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REQUIRED1. Prepare a schedule showing how the profit would be divided,

assuming the partnership profit or loss is:a. $ 102,000b. $ 57,000c. $(34,000)

2. What journal entry should be made to allocate the profit or loss for each of the three cases listed above?

Group Exercise 1: Group Exercise 1: Allocating Profit and Loss, Allocating Profit and Loss, No RestrictionsNo Restrictions

The partnership of Alex and James has the following provisions:• Alex and James receive salary allowances of $37,000 and $18,000,

respectively.• Interest is imputed at 10% on the average capital investment.• Any remaining profit or loss is shared between Alex and James in

a 3:2 ratio, respectively.• Average Capital investments: Alex, $ 50,000; James, 130,000

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Income Summary 102,000Capital, Alex59,400Capital, James42,600

ALLOCATED TOAlex James Total

Total Profit 102,000) Salary 37,000) 18,000) (55,000) Interest on Capital 5,000) 13,000) (18,000) Residual Profit 29,000) Allocate Profit 17,400) 11,600) (29,000)

59,400) 42,600) 0)

Group Exercise 1: Group Exercise 1: Solution for part aSolution for part a

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Total Profit 57,000) Salary 37,000) 18,000) (55,000) Interest on Capital 5,000) 13,000) (18,000) Residual Profit (16,000) Allocate Profit (9,600) (6,400) 16,000)

32,400) 24,600) 0)

Group Exercise 1: Group Exercise 1: Solution for part bSolution for part b

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Capital, Alex 22,200Capital, James 11,800

Income Summary34,000


Total Profit (34,000) Salary 37,000) 18,000) (55,000) Interest on Capital 5,000) 13,000) (18,000)

Residual Profit(107,000)

Allocate Profit (64,200) (42,800) 107,000)

(22,200) (11,800) 0)

Group Exercise 1: Group Exercise 1: Solution for part cSolution for part c

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Methods to Share Profits and Losses: Methods to Share Profits and Losses: “To the “To the Extent Possible” Extent Possible” LimitationsLimitations

When a “limit” provision exists: The next lower level method of sharing can be

reached if and only if there is still unallocated profit remaining after dealing with the current level.

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Group Exercise 2: Allocating Profit and LossGroup Exercise 2: Allocating Profit and Loss——“Limit”“Limit”

Assume the same information provided in Group Exercise 1, except that the partnership agreement stipulates the following order of priority:

1.Salary allowances (only to the extent available)

2.Imputed interest on average capital investments (only to the extent available).

3.Any remaining profit in a 3:2 ratio. (No mention is made regarding losses.)

REQUIRED:The requirements are the same as for Group Exercise 1 (i.e., calculate the allocations and prepare journal entries).a. $ 102,000b. $ 57,000c. $ (34,000)

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Total Profit 102,000) Salary 37,000) 18,000) (55,000) Interest on Capital 5,000) 13,000) (18,000) Residual Profit 29,000) Allocate Profit 17,400) 11,600) (29,000)

59,400) 42,600) 0)

Group Exercise 2: Group Exercise 2: Solution for part aSolution for part a

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Total Profit 57,000) Salary 37,000) 18,000) (55,000)

2,000) Interest on Capital * 556) 1,444) (2,000) Residual Profit 0) Allocate Profit 0) 0) 0)

37,556) 19,444) 0)

Group Exercise 2: Group Exercise 2: Solution for part bSolution for part b

* $2,000 x (5,000 ÷ $18,000) = 556 $2,000 x ($13,000 ÷ $18,000) = 1,444

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Group Exercise 2: Group Exercise 2: Solution for part cSolution for part c

In this case, the partnership agreement is vague. An argument can be made for allocating the loss equally pursuant the UPA 1997 because the partnership agreement is silent with respect to losses.

Alternatively, we could presume that losses were intended to be shared in the residual profit-sharing ratio.

In these cases, the accountant should seek clarification from each partner.

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Matt and Chad created a partnership (M&C) on 12/31/X8 (sharing profits 50/50). Matt contributed equipment from his sole proprietorship having a carrying value of $4,000 and a fair value of $8,000. In 20X9, M&C had profits of $96,000 and borrowed $20,000 from a bank. In 2009, Matt withdrew $35,000 cash. Matt’s Y/E capital balance is

a. $11,000.b. $17,000.c. $21,000. d. $56,000.


a. $11,000.b. $17,000.c. $21,000. d. $56,000.

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a. $11,000.b. $17,000.c. $21,000 ($8,000 + $96,000/2 - $35,000)

d. $56,000.


a. $11,000.b. $17,000.c. $21,000 ($8,000 + $96,000/2 - $35,000)

d. $56,000.

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Make calculations and journal entries to account for changes in

partnership ownership.

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Partner’s Admission: Purchase of An Existing Partner’s Admission: Purchase of An Existing InterestInterest

The purchase of an interest from one or more of a partnership’s existing partners is a: personal transaction between the

incoming partner and the selling partner(s).

The only entry required on the partnership’s books is to transfer an amount: from the selling partner’s Capital

account. to the new partner’s Capital account.

C

Interest $

ABPartnership

A B

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Partner’s Admission: Adding a New PartnerPartner’s Admission: Adding a New Partner

Key Objective Achieve equity among the partners

+ =

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How to Achieve Equity?How to Achieve Equity?

Example

+ =

How much would C have to contribute? What factors would you have to consider?

Cash $100,000 Capital, A $100,000

Land 100,000 Capital, B 100,000

Total Assets $200,000 Total Equity $200,000

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How to Achieve Equity?How to Achieve Equity?

Example

Q: What if the land has a current value of $200,000?

Assume C contributes $150,000 (FMV of value owned by A and B) for a 1/3 interest in assets, profits, and losses.

Q: What if the land is sold the next day for $200,000?

Cash $100,000 Capital, A $100,000

Land 100,000 Capital, B 100,000


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Minimizing InequitiesMinimizing Inequities

The Three Methods The revaluing of assets / goodwill method. The bonus method. The special profit-and-loss sharing

provision method.

Some methods can still result in inequities if events do not materialize as assumed.

≠

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The Three Methods The revaluing of assets / goodwill method. The bonus method. The special profit-and-loss sharing

provision method.

Some methods can still result in inequities if events do not materialize as assumed.

≠

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(1) Revaluing of Assets Method(1) Revaluing of Assets MethodQ: What if the land has a current value of $200,000?A: Simply “revalue” the land before admitting C!

Q: How do you record C’s contribution?

Q: What if the land is sold two years later for $230,000?A: Each gets $10,000 of gain.

Cash $100,000 Capital, A $150,000

Land 200,000 Capital, B 150,000


Land 100,000Capital, A 50,000Capital, B 50,000

Cash 150,000Capital, C 150,000

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Q: Given that the land has a current value of $200,000?

(2) Bonus Method(2) Bonus Method

The partners agree to share equally in all future gains or losses on the disposal of the land. However, C’s capital account is decreased up front by the amount of the first $100,000 of gain that he/she will receive ($33,333). This decrease is added to A’s and B’s capital accounts up front.

Cash 150,000Capital, A 16,667Capital, B 16,667Capital, C 116,667

Q: What if the land is sold two years later for $230,000?

A: Each gets $43,333 of gain.

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(3) Special Profit and Loss Sharing Provision(3) Special Profit and Loss Sharing Provision

Q: Given that the land has a current value of $200,000?

Q: What if the land is sold two years later for $230,000?

A: A and B share equally in the first $100,000 of gain and all partners share equally in the additional $30,000 of gain.

A and B each get $60,000 and C gets $10,000 of the gain.


Specify in the new partnership agreement that the land’s current value is $200,000 and that partners A and B share equally (or in some other specified manner) in the first $100,000 of gain when the land is disposed of.

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Cash $250,000 Capital, A $150,000Capital, B 150,000

Land 200,000 Capital, C 150,000Total Assets $450,000 Total Equity $450,000





(1) Revaluingof assets

(3) SpecialP&LSharing

(2) Bonus

Gain of $30,000 allocated equally to A, B, & C ($10,000 each)

Gain of $130,000: allocate $60,000 to A & B and $10,000 to C

Gain of $130,000 allocated equally to A, B, & C ($43,333 each)

Summary of the Three Methods: Summary of the Three Methods: BeforeBefore Land Land is Sold for $230,000is Sold for $230,000

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Capital, C 160,000



Capital, C 160,000



Capital, C 160,000


(1) Revaluingof assets

(3) SpecialP&LSharing

(2) Bonus

We get the same result under each method!

Summary of the Three Methods: Summary of the Three Methods: After After Land is Land is Sold for $230,000Sold for $230,000

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Only the special profit-and loss sharing provision method will prevent an inequity to one or more of the partners in the event that the agreed-upon values of the assets are

erroneous. the agreed-upon value of goodwill does not

materialize.

≠

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Key Differences Between Revaluation / Key Differences Between Revaluation / Goodwill and Bonus MethodsGoodwill and Bonus Methods

Revaluation/Goodwill Method Revalue the balance sheet by

recording goodwill or revaluing tangible assets.

Thus, we now have a bigger “pie” to divide up among the partners.

Land 100,000Capital, A50,000Capital, B50,000

Excess Value

Book Value of Net Assets

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Revaluation/Goodwill Method Revalue the balance sheet by

recording goodwill or revaluing tangible assets.

Thus, we now have a bigger “pie” to divide up among the partners.

The new partner’s capital account will be equal to his/her ownership percentage of the “Big Pie.”


Land = $100,000

Small Pie =200,000 + 150,000 = 350,000

x 1/3 = $150,000

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Bonus Method Do not revalue the balance sheet. Only leaves the book value of

tangible net assets on the balance sheet.

Book Value of Net Assets

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Bonus Method Do not revalue the balance sheet. Only leaves the book value of

tangible net assets on the balance sheet.

The new partner’s capital account will be equal to his/her ownership percentage of the “Small Pie.”

Small Pie =200,000 + 150,000 = 350,000

x 1/3 = $116,667

Cash 150,000Capital, A16,667Capital, B16,667Capital, C116,667

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The Revaluing of Assets / Goodwill MethodThe Revaluing of Assets / Goodwill Method

Advantages Credit to incoming partner always at least

equal to cash contribution Can be important “psychologically”

Disadvantages Departs from GAAP Complicates income tax preparation

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The Bonus MethodThe Bonus Method

Major Advantages Does not result in a departure from GAAP Minimizes bookkeeping and tax return effort

Mechanics A portion of one or more partner’s capital balance

is transferred to one or more other partners. The hope is that the transferred amount will later be

recouped via future profits.

Incoming partner’s capital account may be less than his/her cash contribution!

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Determining the Value of GoodwillDetermining the Value of GoodwillSteps to follow:

1. Estimate the implied value of the partnership based on the new partner’s contribution. New capital contribution ÷ new partner ownership %

2. Estimate the implied value of the partnership based on the old partners’ total equity. Total old partner capital balance ÷ total old ownership %

3. Calculate the amount of tangible net assets. The sum of old partner capital and new partner contributed

capital.

4. Calculate implied goodwill Implied value (greater of 1 or 2) – tangible net assets (3)

5. Determine whether the new or old partners possess goodwill. The smaller of 1 or 2 The one who paid less for their relative share.

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Practice Quiz Question #5aPractice Quiz Question #5a

Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). The old partners capital accounts are not to decrease (i.e., use the Revaluation / Goodwill method). Betsy’s capital account is credited: the parent’s income is always lower under the modified equity method.a.$ 9,000b.$54,000c.$58,500d.$60,000e.$76,500

Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). The old partners capital accounts are not to decrease (i.e., use the Revaluation / Goodwill method). Betsy’s capital account is credited: the parent’s income is always lower under the modified equity method.a.$ 9,000b.$54,000c.$58,500d.$60,000e.$76,500

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Solution, SummarySolution, Summary

1. New implied value: $ 54,000 ÷ 25% = $ 216,0002. Old implied value: $180,000 ÷ 75% = $ 240,0003. Tangible net assets: $180,000 + $54,000 = $ 234,0004. Implied Goodwill = $240,000 $234,000 = $ 6,0005. Goodwill belongs to new partner (because

$216,000 is less than $240,000). [Implies thatshe paid less for her relative share of the business.]

Since we’re evaluating, use the BIG pie:

x 25% = $60,000

GW = 6,000

234,000

The BIG PIE (Tangible + Goodwill)

The SMALL PIE (Tangible Only)

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Practice Quiz Question #5a Practice Quiz Question #5a SolutionSolution

Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). The old partners capital accounts are not to decrease (i.e., use the Revaluation / Goodwill method). Betsy’s capital account is credited: the parent’s income is always lower under the modified equity method.a.$ 9,000b.$54,000c.$58,500d.$60,000 ($240,000 x 25%) e.$76,500

Betsy’s share of the “big pie.”

Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). The old partners capital accounts are not to decrease (i.e., use the Revaluation / Goodwill method). Betsy’s capital account is credited: the parent’s income is always lower under the modified equity method.a.$ 9,000b.$54,000c.$58,500d.$60,000 ($240,000 x 25%) e.$76,500

Betsy’s share of the “big pie.”

Cash 54,000Goodwill

6,000Capital, Betsy

60,000

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Practice Quiz Question #5bPractice Quiz Question #5b

Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). Use the Bonus Method. Betsy’s capital account is crediteda.$ 9,000.b.$54,000.c.$58,500.d.$60,000.e.$76,500.

Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). Use the Bonus Method. Betsy’s capital account is crediteda.$ 9,000.b.$54,000.c.$58,500.d.$60,000.e.$76,500.

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Practice Quiz Question #5b Practice Quiz Question #5b SolutionSolution

Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). Use the Bonus Method. Betsy’s capital account is credited:a.$ 9,000.b.$54,000.c.$58,500.d.$60,000.e.$76,500.

Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). Use the Bonus Method. Betsy’s capital account is credited:a.$ 9,000.b.$54,000.c.$58,500.d.$60,000.e.$76,500.

Small Pie = 180,000 + 54,000 = 234,000

x 25% = $58,500Since we’re not revaluating, use the Small pie:

Betsy’s share of the “Small Pie.”

Cash 54,000Capital, Old Part. 4,500

Capital, Betsy58,500

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Group Exercise: Goodwill Method Group Exercise: Goodwill Method

Scott and Stephanie are partners with capital balances of $100,000 and $65,000, and they share profits and losses in the ratio of 3:2, respectively. Zoe invests $60,000 cash for a 25% interest in the capital and profits of the new partnership. The partners agree that the implied partnership goodwill is to be recorded simultaneously with the admission of Zoe.

REQUIRED

1.Calculate the firm’s total implied goodwill.

2.Prepare the entry or entries to record the admission of Zoe.

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1. New implied value: $ 60,000 ÷ 25% = $ 240,0002. Old implied value: $165,000 ÷ 75% = $ 220,0003. Tangible net assets: $165,000 + $60,000 = $ 225,0004. Implied Goodwill = $240,000 $225,000 = $ 15,0005. Goodwill belongs to old partners (because

$220,000 is less than $240,000). [Implies thatthey “gave” less for her relative share of the business.]



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Note that this is 25% of the “Big Pie” because we revalue

the balance sheet!

Group Exercise: Goodwill Method Group Exercise: Goodwill Method Solution Solution

Entry to record Goodwill

Entry to record Goodwill

Goodwill 15,000Capital, Scott 9,000Capital, Stephanie 6,000

Cash 60,000Capital, Zoe 60,000

x 25% = $60,000

GW = 15,000

165,000 + 60,000 = 225,000

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Group Exercise: Bonus Method Group Exercise: Bonus Method

Jim and June are partners who share profits and losses in the ratio of 2:1, respectively. On 12/31/X8 their capital accounts are as follows:

Jim $ 40,000June 30,000Total $ 70,000

On that date, they agreed to admit Mel as a partner with a 30% interest in the capital and profits and losses for an investment of $15,000. The new partnership will begin with a total capital of $85,000.

REQUIREDPrepare the entry or entries to record the admission of Mel.

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1. New implied value: $ 15,000 ÷ 30% = $ 50,0002. Old implied value: $ 70,000 ÷ 70% = $ 100,0003. Tangible net assets: $ 70,000 + $15,000 = $ 85,0004. Implied Goodwill = $100,000 $85,000 = $ 15,0005. Goodwill belongs to new partner (because

$50,000 is less than $100,000). [Implies thathe “gave” less for his relative share of the business.]



Note that we use the small pie here with bonus method.

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Note that this is 30% of the“Small Pie” because we don’t revalue the balance sheet!

Group Exercise: Goodwill Method Group Exercise: Goodwill Method Solution Solution

Entry to record admission of MelCash 15,000Capital, Jim 7,000Capital, June 3,500

Capital, Mel 25,500

x 25% = $60,000

Small Pie =70,000 + 15,000 = 85,000

Note: The bonus to the new partner is shared between the old partners in their old profit and loss sharing ratio of 2:1.

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Comprehensive Group ProblemComprehensive Group Problem

Jenn and Amanda are in partnership—they share profits and losses in the ratio of 7:1, respectively, and they have capital balances of $30,000 each. The partnership’s land has a fair value of $30,000 in excess of book value. Tommy is admitted into the partnership for a cash contribution of $25,000. The new profit and loss sharing formula is Jenn, 70%, Amanda, 10%, and Tommy, 20%. The value of the partnership’s existing goodwill is agreed to be $10,000.

REQUIRED1.Prepare the required entries, assuming the land is to be revalued and the goodwill is to be recorded on the partnership’s books.2.Prepare the required entries, assuming that the bonus method is to be used with respect to the undervalued tangible assets and the goodwill.

Note that this goodwill number is given because it is a bit harder to calculate when there is also unrecorded appreciation in tangible assets. However, the next slide shows the calculation.

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1. New implied value: $ 25,000 ÷ 20% = $ 125,0002. Old implied value: $ 90,000 ÷ 80% = $ 112,5003. Tangible net assets: $ 60,000 + $30,000 + $25,000 =

$115,0004. Implied Goodwill = $125,000 $115,000 = $ 10,0005. Goodwill belongs to the old partners (because

$112,500 is less than $125,000). [Implies that they“gave” less for their relative share of the business.]



Added excess land value to isolate GW!

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Note that this is 20% of the

“Big Pie.”

Comprehensive Group Problem Comprehensive Group Problem SolutionSolutionPART 1 (Revaluation / Goodwill Method):

To revalue tangible assets to their current values.

To record goodwill.

To record cash contribution by Tommy.

Land 30,000Capital, Jenn 26,250Capital, Amanda 3,750

Goodwill 10,000Capital, Jenn 8,750Capital, Amanda 1,250

Cash 25,000Capital, Tommy 25,000

x 20% = $25,000

GW = 10,000

60,000 + 25,000 = 85,000

Land = 30,000

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Comprehensive Group Problem Comprehensive Group Problem SolutionSolutionPART 2 (Bonus Method):

If the partnership were sold one day after Tommy was admitted and the selling price was $40,000 more than the book value of the net assets, Tommy would share in the $40,000 gain to the extent of $8,000 (20% × $40,000), the amount of his capital contribution that is given as a bonus to Jenn and Amanda.

Cash 25,000Capital, Jenn 7,000Capital, Amanda 1,000Capital, Tommy 17,000

Note that this is 20% of the“Small Pie” without revaluingthe land ($60,000 + $25,000).

x 20% = $17,000

Small Pie =60,000 + 25,000 = 85,000 Note: The bonus to be given the old partners is Tommy’s

profit and loss sharing percentage of 20% multiplied by the sum of the undervalued tangible assets ($30,000) and the goodwill ($10,000).

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Legal Aspects: Joining a PartnershipLegal Aspects: Joining a Partnership

A major risk of joining an existing partnership is the general practice of requiring the new partner to become jointly responsible for all pre-existing partnership liabilities.

all pre-existing contingent liabilities.

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Legal Aspects: Withdrawing from a PartnershipLegal Aspects: Withdrawing from a Partnership

A partner that withdraws from a partnership is still responsible for the following items that exist at the time of the withdrawal: all partnership obligations, and all contingent liabilities,

Only creditors can expressly release a partner from this responsibility.

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Legal Aspects: Withdrawing from a PartnershipLegal Aspects: Withdrawing from a Partnership

Disassociation A broad term that refers to when a partner is no

longer associated with a partnership.

Dissolution A narrow term that refers to when a

(1) partnership is dissolved, and

(2) its affairs must be wound up. Thus, the partnership’s existence is terminated.

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Upon withdrawal from a partnership, Cliff received $14,000 cash in excess of his capital balance. Cliff’s share of profits and losses was 20%. Partnership land was undervalued by $50,000. The total partnership goodwill isa.$ 4,000.b.$20,000.c.$24,000d.$70,000.

Upon withdrawal from a partnership, Cliff received $14,000 cash in excess of his capital balance. Cliff’s share of profits and losses was 20%. Partnership land was undervalued by $50,000. The total partnership goodwill isa.$ 4,000.b.$20,000.c.$24,000d.$70,000.

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SolutionSolution

Excess value of land $50,000x 20%

Cliff’s share $10,000

Total excess payment $14,000 Share of land excess 10,000

Cliff’s share of goodwill $ 4,000

20%Total Goodwill $20,000

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Upon withdrawal from a partnership, Cliff received $14,000 cash in excess of his capital balance. Cliff’s share of profits and losses was 20%. Partnership land was undervalued by $50,000. The total partnership goodwill isa.$ 4,000.b.$20,000. (5 x [$14,000 - {20% x $50,000}]) c.$24,000d.$70,000.

Upon withdrawal from a partnership, Cliff received $14,000 cash in excess of his capital balance. Cliff’s share of profits and losses was 20%. Partnership land was undervalued by $50,000. The total partnership goodwill isa.$ 4,000.b.$20,000. (5 x [$14,000 - {20% x $50,000}]) c.$24,000d.$70,000.

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Group Exercise: Retirement Group Exercise: Retirement

The 6/30/X8 balance sheet of the partnership of Sandy, Rees, and Raymond as follows. The partners share profits and losses in the ratio of 2:2:6, respectively.

Assets at cost $145,000Sandy, loan 9,000Other liabilities 17,000Capital, Sandy 20,000Capital, Rees 37,000Capital, Raymond 62,000

Sandy retires from the partnership. By mutual agreement, the assets are to be adjusted to their fair value of $150,000 at 6/30/X8. Rees and Raymond agree that the partnership will pay Sandy $45,000 cash for her partnership interest, exclusive of her loan, which is to be paid in full. No goodwill is to be recorded.

REQUIRED1.Prepare the entry to record the revaluation of assets to fair value.2.Prepare the entry to record Sandy’s retirement.3.What is the implicit total goodwill for the partnership?

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Group Exercise Group Exercise SolutionSolution

PART 1

Assets 5,000Capital, Sandy 1,000Capital, Rees 1,000Capital, Raymond 3,000

PART 2

Capital, Sandy 21,000Capital, Rees 6,000Capital, Raymond 18,000

Cash 45,000

PART 3

To revalue assets to their current value.

To record the withdrawal of Sandy.

Sandy received a bonus of $24,000, which was equal to her share of the goodwill. Because Sandy’s profit and loss sharing ratio was 20%, the total goodwill must have been $120,000 ($24,000 ÷ 20%).

Conclusion

The EndThe EndThe EndThe End

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partnerships: formation, operation, and changes in membership

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