Chapter 15

PARTNERSHIPS -- FORMATION, OPERATIONS, AND CHANGES

IN OWNERSHIP INTERESTS
Comprehensive Chapter Outline
NATURE OF PARTNERSHIP ORGANIZATION
A

Partnership is defined as an association of two or more persons to carry on as coowners of a business for profit.

Characteristics

Limited life - the legal life of a partnership terminates with the admission of a new
partner, withdrawal or death of an old partner, voluntary dissolution by the
partners, or involuntary dissolution.

Mutual agency - each partner is assumed to be an agent for the partnership with
the power to bind all the other partners by his/her actions on behalf of the
partnership.

Unlimited liability - each partner is liable for all partnership debts.

Articles of partnership (the partnership agreement) should be written (but oral

agreements may be legal and binding)
1

The agreement should specify the types of products and services to be provided
and other details of the business, rights and responsibilities of partners, initial
investments, provisions for additional investments , asset drawing provisions,
profit and loss sharing formulas, and procedures for dissolving the partnership.

Profits and losses are divided equally if there is no specific partnership

agreement.

Partnerships do not pay federal income taxes, but the IRS requires filing of a financial
information return.

INVESTMENTS AND DISINVESTMENTS (Illustration 15-1)

A

Initial investments
1

All property brought into the partnership or acquired by the partnership is

partnership property.

Initial investment is recorded in the partners capital accounts at its fair value at
the time of transfer to the partnership.

Unidentifiable assets in initial investment:

a
b

Bonus approach - the unidentifiable asset is not recorded on the

partnership books and the capital accounts are adjusted to meet the
conditions of the partnership agreement
Goodwill approach - the unidentifiable asset is measured and recorded by
reference to the total partnership capital implied by the other partners
investment divided by the other partners interest

Additional investments - The same valuation rules apply for additional investments as
apply for initial investments.

Withdrawals are large and irregular disinvestments charged directly to partners capital
accounts.

Drawings, drawing allowances, and salary allowances are:

Regular amounts that are withdrawn in anticipation of profits and charged to

individual partner drawings accounts.

Closed to the capital accounts at the end of each accounting period, before
preparation of the partnership balance sheet.

Loans and advances

1

Loans made to the partnership by a partner earn interest and are considered
liabilities of the partnership.

Loans made to a partner by the partnership are partnership assets

PARTNERSHIP OPERATIONS
A

Financial statements of a partnership include a balance sheet, an income statement, a

statement of partnership capital, and a statement of cash flows.

Profit and loss sharing agreements provide for the division of profits.
1
2
3

Salaries and bonuses to partners and interest on capital accounts are not expenses
and do not affect the measurement of partnership income.
The order of the partnership agreement is followed regardless of the income or
loss experienced by the partnership.
Losses are divided the same as profits if there is no specific agreement for losses.

Capital to be considered in profit and loss sharing agreements may be beginning,

ending, or average capital balances. Average capital means weighted average
unless otherwise specified in the partnership agreement.

CHANGES IN PARTNERSHIP INTERESTS

A

Assignment of an interest:
1

The partnership is not dissolved.

An assignee does not become a partner.

The assignee is entitled to partners share of profits and losses and a share of
partnership assets in the event of liquidation.

The only accounting necessary is to record the capital transfer from the assignor
to the assignee.

Admission of a new partner, either by purchasing an interest from old partners or

investing in an existing partnership:
1

Admission of a new partner requires consent of all existing partners

The old partnership is dissolved.

A new partnership agreement is developed.

Without a new agreement, profits and losses are divided equally among the
partners.

Purchase of an interest from existing partners:

1

The partnership receives no new capital.

Revaluation/goodwill procedure
a

The revaluation should be completed before the admission of the new

partner.

Since the partnership receives no money, the amount paid to the old
partners provides little evidence for revaluation and appraisals must be
relied on for an equitable distribution of total partners capital.

Identifiable assets and liabilities are revalued before goodwill is recorded.

Goodwill is amortized over a maximum of 40 years.

e
3

An entry is made to transfer capital from the selling partner(s) to the new
partner.

Nonrevaluation/bonus procedure
a

The bonus procedure requires entry to transfer capital of old partners to

new partners capital account.

Without revaluation, new partners capital account may not equal his or
her payments to the old partners.

INVESTING IN AN EXISTING PARTNERSHIP

A

The old partnership is legally dissolved.

Noncash investments are valued using the same valuation techniques as used for initial
investments.

Investment of the new partner is recorded under the provisions of the new partnership
agreement.

Basis for revaluation of the partnership:

1

If the new partners capital interest in the total of the old capital plus new
investment is less than the new partners investment, there is an implication that
the old partnership had unrecorded asset value. (Illustration 15-2)
a

Revaluation is determined by dividing the new partners capital

investment by his or her interest in the new partnership.

The unrecorded asset value may be recognized by the goodwill or bonus

approach.
(1)

(2)

Goodwill approach:
(a)

The difference between the implied value and the total of

the old capital plus the new investment is goodwill.

(b)

The goodwill is divided among the old partners in their old

profit and loss sharing ratios before the admittance of the
new partners.

Bonus approach: The assets are not revalued, but the difference
between the new partners investment and his/her capital credit is
divided among the old partners in their old profit sharing ratios.

If the new partners capital interest in the total of the old capital plus new
investment is greater than the new partners investment, there is an implication

that the new partner is bringing unidentifiable assets into the partnership.
(Illustration 15-3)
a

The total capital of the new partnership is determined by dividing the old
partners capital by the old partners interest retained in the new
partnership.

The unidentifiable asset value from the incoming partner can be

recognized by either the goodwill or the bonus approach.
(1)

Goodwill approach: Assets are revalued to their fair values and

goodwill to the new partner is recorded.

(2)

Bonus approach:
(a)

Assets are not revalued

(b)

Capital balances of the old partners are reduced for the

bonus to the new partner and the new partners capital
account is recorded according to the partnership
agreement.

DISSOLUTION OF A CONTINUING PARTNERSHIP THROUGH DEATH OR

RETIREMENT
A

The old partnership is dissolved and the retiring partner (or estate of a deceased partner)
receives a settlement.

If the partnership agreement does not specify a settlement, Section 42 of the Uniform
Partnership Act requires the following:
1
2

The deceased or retiring partners interest is valued at the date of dissolution.

The retiring partner, or estate of the deceased partner, receives that amount plus
interest as an ordinary creditor.
a

If there is a time lapse between the dissolution and settlement dates, the
capital balance is reclassified as a liability.

Any interest on the liability up to the settlement date is an expense of the

partnership.

Recording the settlement with a retiring or deceased partner:

1

If the retiring partner receives an amount equal to his or her final capital balance,
the only entry is a debit to the capital account and a credit to cash.

If the retiring partner receives more than the balance in his or her capital account,
an undervaluation of the partnership on the partnership books is implied. The
excess payment can be recorded in one of three ways
a

Bonus to the retiring partner: The excess payment to the retiring partner
is charged to the remaining partners in their relative profit sharing ratios.

Goodwill equal to the excess payment to the retiring partner is recorded:

Goodwill is recorded to the extent paid for by the continuing partnership,
in other words, only the retiring partners share of partnership assets is
revalued.

Revaluation of total partnership capital based on the excess payment to

the retiring partner:
(1)

A total undervaluation of the partnership is determined by dividing

the excess payment to the retiring partner by the retiring partners
profit-sharing ratio.

(2)

The goodwill is recorded and credited to all partners capital

accounts before settlement with the retiring partner.

If the retiring partner receives less than the balance of his or her account, the
partners may agree that the partnership is worth less than its book value.
a

Overvalued assets should be written down to fair values in the partners

profit-sharing ratios before settlement with the retiring partner.

Bonus to continuing partners: A bonus equal to the excess of the retiring

partners capital account over the cash paid by the partnership in
settlement of the retiring partners interest is credited to the continuing
partners capital account balances in their relative profit-sharing ratios.

LIMITED PARTNERSHIPS
A

The unlimited liability characteristic is circumvented in this instance.

1

The limited partnership consisits of at least one general partner, who has unlimited
liability, and one or more limited partners whose risk whose risk is limited to their
equity interest in the venture.

The limited partner is excluded from the management of the entity.

B
The partnership agreement must be written, signed by the partners, and filed with the
appropriate state agency.
Description of assignment material

Minutes

Questions (16)
Exercises
E15-1
E15-2
E15-3
E15-4
E15-5
E15-6
E15-7
E15-8
E15-9
E15-10
E15-11
E15-12
E15-13
E15-14
E15-15
E15-16

(21)
[Carson/Lamb] Calculate inequity on initial investment
[Arnold/Beverly/Carolyn] Income allocation with bonus to Beverly
[Vannah/Wanine/Ully] Income allocation with salary allowance and
interest on average capital balances
[Melanie/David] Income allocation with error from the previous year
[Bird/Cage/Dean] Statement of partnership capital
[Batty/Iggy/Grabby] Assignment of an interest
[Klaxon/Bell/Ring] Admission of partner (payment to existing partners)
[Bowen/Monita/Johnson] Journal entries for admission of partner
(payment to existing partners; assets are revalued)
[Sprint/Telico/Univar/Vernon] Journal entries for admission of partner
(investment in partnership; assets revalued)
[Manda/Nimball/Ojas/Roscoe] Determine partners capital balances
and profit and loss sharing ratios after admission of partner (investment
in the partnership; assets are not revalued)
[Nixon/Mann/Peter] Journal entries for retirement of partner (assets
revalued)
[Beck/Dee/Lynn] Determine capital balances after retirement of a
partner with a loan balance
[Kathy/Eddie] Income allocation with salary and bonus
[Byder/Cegal/Danner/Evita] Journal entries to record retirement of
a partner under 3 assumptions
5 MC problem-type questions
5 MC problem-type questions

10
12
15
10
20
10
12
16
20
20
15
15
10
20
25
25

E15-17
E15-18
E15-19
E15-20
E15-21

AICPA 5 MC problem-type questions

AICPA 7 MC problem-type questions
[Kray/Lamb/Mann] Statement of partners capital
[Grosby/Hambone/Iota] Computations (admission of new partner)
[Case/Donley/Early] Journal entries for retirement of partner under
three assumptions

Problems
P15-1
P15-2

(14)
[Ellen/Fargo/Gary] Prepare a statement of partnership capital
[Mortin/Oscar/Trent] Prepare a balance sheet after the admission of a
new partner (noncash investment; assets revalued)
[Ashe/Barbour] Income distribution schedule (allocation includes
interest, salary, bonus)
[Alex/Carl/Erika] Income allocation schedule with loss, statement of
partners capital, and correcting journal entries
[Katie/Lynda/Molly] Income and loss allocation under three
assumptions (capital balances, bonus, interest)
[Jones/Keller/Glade] Computations and correcting entry (income
allocation over three years with errors)
[Addie/Bailey/Cathy] Journal entries and balance sheet (admission of
partner)
[Abed/Batak/Cabel/Darling] Admission of partner under 4 independent
assumptions
[Pat/Mike/Hay/Con] Journal entries (investment in a partnership vs.
purchase of an interest)
[Aida/Thais/Carmen] Journal entries (admission of a partner under
four assumptions)
[Harry/Iona/Jerry] Statement of partnership capital for two years
(incomplete records)
[Drinkard/Boone] Schedules and statement of partners capital
(alternative profit sharing agreements)
[Peter/Quarry/Sherel] Journal entries for admission of new partner
(three situations and alternative revaluation and nonrevaluation
assumptions)
[Killer/Lassie] Allocate income to partners and determine average
capital balances (partnership net income is not given)

P15-3
P15-4
P15-5
P15-6
P15-7
P15-8
P15-9
P15-10
P15-11
P15-12
P15-13
P15-14

25
35
25
15
20

25
20
16
40
35
60
20
30
35
25
40
50
45
20

ELECTRONIC SUPPLEMENT
The electronic supplement contains a detailed outline of the Uniform Partnership Act (1914) that is referred to
throughout this chapter and chapter 16.

Illustration 15-1
SUMMARY OF PARTNERSHIP ORGANIZATION AND OPERATIONS
Partnership formation
*
Noncash assets invested in a partnership are recorded at their fair values (i.e.,
present values for receivables and current cost for inventories and other assets.
*

Partner liabilities assumed in a partnership formation should be recorded at their present

values as indicators of their fair market values.

Failure to record assets invested and liabilities assumed at the fair values results in
individual partner inequities.

Partnership income (loss)

*
Income or loss should be distributed in accordance with the partnership agreement. In
the absence of an agreement, income or loss is shared equally.
*

Partnership profit and loss sharing agreements frequently specify allocations for partner
salaries, interest on capital account balances, and bonuses. Such items do not constitute
expenses of the partnership.

Residual income or loss of a partnership should be allocated according to the residual

profit and loss sharing ratios.

Partnership dissolution
*
A partnership entity is dissolved in a legal sense whenever there is an ownership change
in the partnership.
*

Dissolution of a partnership entity in a legal sense does not necessarily mean liquidation
of the partnership business.

The admission or withdrawal of a partner is recorded under the bonus or the goodwill
procedure.

An individual may become a partner by purchasing an interest from an existing partner,

or by investing cash or other resources in the partnership.
a

All existing partners must agree to the admission of a new partner.

Partnership assets may or may not be revalued upon the admission or withdrawal
of a partner.

Illustration 15-2
INVESTMENT IN AN EXISTING PARTNERSHIP
Pat and Mike are partners with capital balances of $50,000 and $40,000, respectively,
and they share profits and losses equally. They admit Sid for a 30% interest for a cash
investment of $60,000.
1

Bonus procedure (Assets not revalued)

Journal entry to record Sid's admission:

Cash

$60,000
Pat Capital
$ 7,500
Mike capital
7,500
Sid capital
45,000
Old capital of $90,000 + $60,000 investment = $150,000 new capital.
New balances: Pat $57,500; Mike $47,500; Sid $45,000 = $150,000.

Goodwill procedure

Journal entry to record revaluation

Goodwill
$50,000
Pat capital
$25,000
Mike capital
25,000
Investment of $60,000/30% interest = $200,000 implied total capital.
Total capital $200,000 - ($90,000 old capital + $60,000 new investment) =
$50,000 goodwill.
Journal entry to record admission of Sid:
Cash

$60,000
Sid capital
$60,000
New balances: Pat $75,000; Mike $65,000; Sid $60,000 = $200,000.

Illustration 15-3
INVESTMENT IN AN EXISTING PARTNERSHIP
Pat and Mike are partners with capital balances of $50,000 and $40,000, respectively.
They share profits and losses equally. They admit Sid to a 30% interest for a cash investment of
$30,000.
1

Bonus procedure (Assets not revalued)

Journal entry to record Sid's admission:

Cash
Pat capital
Mike capital

$30,000
3,000
3,000

Sid capital
$36,000
Old capital of $90,000 + $30,000 investment = $120,000 new capital.
Sid capital = $120,000 new capital x 30% interest = $36,000.
Sids capital credit $36,000 - $30,000 cash payment = $6,000 bonus to new partner.
New balances: Pat $47,000; Mike $37,000; Sid $36,000 = $120,000 total capital.
2

Goodwill procedure (Assets revalued)

Journal entry to record admission of Sid and revaluation:

Cash
Goodwill

$30,000
8,571

Sid capital
$38,571
Old capital $90,000/70% interest retained by old partners = $128,571 (rounded) new
capital. New capital $128,571 - ($90,000 old capital + $30,000 investment) =
$8,571. New balances: Pat $50,000; Mike $40,000; Sid $38,571 = $128,571.