Chapter 15: Partnerships –

Formation, Operations, and

Changes in Ownership Interests
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn

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 Partnerships: Objectives
1. Comprehend the legal characteristics of
partnerships.
2. Understand initial investment valuation and
record keeping.
3. Grasp the diverse nature of profit and loss
sharing agreements and their computation.
4. Value a new partner's investment in an existing
partnership.

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 Objectives (cont.)
5. Value a partner's share upon retirement or
death.
6. Understand limited liability partnership
characteristics.

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Partnerships – Formation, Operations, and Changes in
Ownership Interests
1: Characteristics of Partnerships

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 Partnerships
RUPA "Revised Uniform Partnership Act"
– Entity theory:
• partners own their share of the partnership,
but not its individual assets
– Dissociation:
• partners can dissociate without dissolution
Partners have
– Mutual agency
– Unlimited liability

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 Articles of Partnership
1. Products or services, line of business
2. Partner rights & responsibilities
3. Initial investment and value assigned to
noncash investments
4. Additional investment conditions
5. Asset withdrawals
6. Profit and loss sharing
7. Dissolution procedures

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 Partnership Reporting
• Financial reporting should provide for the
needs of
– Partners
– Creditors of the partnership
– IRS

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Partnerships – Formation, Operations, and Changes in
Ownership Interests
2: Initial Investment

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 Initial Investment
Cash XXX
Amy Capital XXX
Cash XXX
Paul Capital XXX
A partnership is started by Amy and Paul, each
investing cash.
If they invest other assets, the value of those assets
should be agreed upon in advance.
Cash XXX
Equipment XXX
Land XXX
Paul Capital XXX
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 Initial Investment with Bonus or
Goodwill
Partner initial investments, at fair value, will not
represent their ownership.
– Individual talent
– Business connections
– Customer base
Partners choose method
– Bonus method
• Adjustment within the capital accounts
– Goodwill method
• Goodwill is recorded on the books
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 Initial Investment with Bonus
Total fair value received is split, as desired,
between partners
Cola invests land and building worth $10 and $40.
Crown invests cash and inventory at $7 and $35.
Agree to have equal shares:
(10 + 40 + 7 + 35) / 2 = $46 each
Cash 7
Inventory 35
Land 10
Building 40
Cola Capital 46
Crown Capital 46
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 Initial Investment with Goodwill
If Cola and Crown agree to equal shares, use
larger implied total value of firm.
Cola's: (10 + 40) / 50% = $100
Crown's: (7 + 35) / 50% = $84
Implied value of firm $100
Cola's 50%(100) $50 Crown's 50%(100) $50
He invests: He invests:
Land $10 Cash $7
Building $40 $50 Inventory $35 $42
Goodwill $8

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 Initial Entry with Goodwill
Land 10
Building 40
Cola Capital 50
To record Cola's investment
Cash 7
Inventory 35
Goodwill 8
Crown Capital 50
To record Crown's investment and goodwill

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 Partner Accounts
Each partner has his/her own accounts for
– Capital
– Drawings (periodic, salary-like, amounts)
– Withdrawals (other, large, unusual amounts)
• Investments increase Capital
• Drawings and withdrawals are closed to Capital
• Income Summary or Revenue and Expense
Summary is closed to Capital.

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 Sample Partner Closing Entries
Drawings / Amy Capital XXX
withdrawals Amy Drawings XX
are closed to
individual Amy Withdrawals XX
capital Reduces Amy's capital for drawings and withdrawals
accounts. Paul Capital XXX
Paul Drawings XXX
Income Summary Profit
Amy Capital XXX
Paul Capital XXX
To share profits between Amy and Paul
Income is shared between the partners. A loss would cause
the entry to be reversed. It is possible for some partners to
have losses while other have profits.
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 Statement of Partners' Capital

Beginning capital + investments – drawings and/or withdrawals

+ income or – loss = ending capital
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Partnerships – Formation, Operations, and Changes in
Ownership Interests
3: Sharing Profit and Loss

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 Profit/ Loss Sharing Agreements
The partnership articles should clearly state the
means of distributing profits and distributing
losses.
Items commonly considered
– Bonus allowance
– Salary allowance
– Interest allowance on capital invested
• Based on average, beginning or ending
capital balance
– Sharing of remaining amounts
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 Bonus and Salary Allowances
Bonus allowances are often based on partnership
profits and may be before or after:
(a) salary allowances and (b) bonus.
If the bonus is after both:
Bonus = b% x (NI – Salary Allow – Bonus)

Salary allowances are generally pre-determined

amounts

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 Interest Allowances and Capital
Interest Allowances are generally based on a
measure of the partner's capital
– Beginning of the year capital balance
– Average* capital balance for the year
Weighted average balance
– Ending* capital balance
Beginning balance – withdrawals + investments
* Periodic drawings are often ignored, although
withdrawals are considered

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 Allocating Income
Partner's allowances for bonus, salary and
interest are allocated to them, whether or not
sufficient profits exist.
Remaining profits (or deficit) is then split
according to the agreed-upon proportions.

These are general procedures. The partnership

articles provide the specific requirements.

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 Example: Sharing Profits
Tom and Betty agree to share profits and losses:
• Tom and Betty have $60 and $30 salary allowances
• Betty has a bonus of 50% of profits in excess of $500
• Each have interest allowances of 10% of beginning
capital
– Tom Capital, 1/1 $400
– Betty Capital, 1/1 $350
• Remaining profits or losses are shared Tom 60%, Betty
40%.
Partnership profits are $660 for the year.

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 Share Profits of $660
Total Tom Betty
Net income $660
Salary allowance (90) $60 $30
Bonus allowance (80) 0 80
Interest allowance (75) 40 35
Subtotal $415
Split 60:40 (415) 249 166
Allocated net income $0 $349 $311

Bonus = 50%(660 - 500) = 80

Tom Interest = 10%(400) = 40
Betty Interest = 10%(350) = 35
60%(415) = 249; 40%(415) = 166
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 Share Profits of $180
Assume instead that income was only $180.
Total Tom Betty
Net income $120
Salary allowance (90) $60 $30
Bonus allowance 0 0 0
Interest allowance (75) 40 35
Subtotal, deficit ($45)
Split 60:40 45 (27) (18)
Allocated net income $0 $73 $47
Bonus = zero, income does not exceed threshold
Tom Interest = 10%(400) = 40
Betty Interest = 10%(350) = 35
60%(-45) = -27; 40%(-45) = -18
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Partnerships – Formation, Operations, and Changes in
Ownership Interests
4: Admitting a New Partner

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 Admitting a New Partner
1. A current partner assigns interest to new
partner.
2. New partner purchases interest from existing
partner.
• Goodwill method
• Bonus method
3. New partner invests directly in partnership.
• Goodwill method
• Bonus method

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 Assignment
Assignment gives the assignee right to a share of
future earnings and share of assets in
liquidation
– Not a partner
– No share in management
Old Partner Capital XXX
Assignee Capital XXX

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 Buy from Partner: Simple
Alfano and Bailey have capital balances of $50
each and each have a 50% interest in the firm.
Cobb buys half of Alfano's interest for $25.
Alfano Capital 25
Cobb Capital 25
Before After
Capital Share Capital Share
Alfano $50 50% $25 25%
Bailey 50 50% 50 50%
Cobb 25 25%
Total $100 $100
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 Buy from Partner: Goodwill
Don and Ed have capital of $50 and $40 with each
50% interest.
Fay will pay $60 directly to the partners and
receive 50% interest in the firm. Don and Ed
each keep 25%. Assets are at fair value.
Implied value of firm, $60/.50 120
Old capital, $50 + 40 90
Goodwill 30
The goodwill increases Don & Ed's capital each
by $15.
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 Goodwill Revalues Capital
After
Before Revaluation revaluation Transfer Final
Don $50 $15 $65 ($35) $30
Ed 40 15 55 (25) 30
Fay 60 60
Total $90 $120 $120
Presumably, Fay paid $35 to Don and $25 to Ed.
If the partners had not wanted to realign the
capital, the capital of Don and Ed would each
be reduced by $30 to transfer the $60 to Fay.

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 Buy from Partner: Bonus
If Don and Ed had decided not to revalue the
assets or record goodwill, the bonus method is
used. Before Transfer Final
Don $50 ($27.5) $22.5
Ed 40 (17.5) 22.5
Fay 45.0 45.0
Total $90 $90.0
Fay's capital is 50%(90) = $45.
Don and Ed Capital accounts are adjusted to their
new balances 25%(90) = $22.5
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 Entries for Purchase from Partner
Entries for Fay's admission, under goodwill and
bonus methods:
Goodwill 30
Don Capital 15
Ed Capital 15
Don Capital 35
Ed Capital 25
Fay Capital 60
Goodwill method, aligning capital accounts
Don Capital 27.5
Ed Capital 17.5
Fay Capital 45
Bonus method, aligning capital accounts
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 Invest in Business: Goodwill
Andrew and Boyles have capital balances of $40
and $40 and share equally in the firm.
Criner will be admitted with an investment of $50
cash. All three will have equal shares. Net assets
are at fair value; goodwill will be recorded.
Implied value of firm, $50/(1/3) $150
Old capital, $40 + 40 $80
Additional investment 50 130
Goodwill $20
Criner: $130*1/3 = $43.3, but he pays $50 … so
goodwill goes to old partners.
Implied firm value is based on Criner's investment.
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 Investment and Goodwill Add to
Capital (Goodwill to Old Partners)
Revalu- After re-
Before ation valuation Investment Final
Andrew $40 $10 $50 $50
Boyles 40 10 50 50
Criner $50 50
Total $80 $100 $150
Capital of $80 at the start, increases by the $20
goodwill and the $50 cash investment.

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 Invest in Business: Goodwill
Andrew and Boyles have capital balances of $40
and $40 and share equally in the firm.
Criner will be admitted with an investment of $50
cash. Criner will be given a 40% share; Andrew
and Boyles will each have 30%. Net assets are at
fair value; goodwill will be recorded.
Implied value of firm, $80/(.60) $133.3
Old capital, $40 + 40 $80
Additional investment 50 130.0
Goodwill $3.3
Criner: $130*40% = $52, but he pays $50 … so goodwill
goes to new partner.
Implied firm value is based on old partners' capital and
retained interest.
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 Investment and Goodwill Add to
Capital (Goodwill to New Partner)
Revalu- After re-
Before ation valuation Investment Final
Andrew $40 $40 $40.0
Boyles 40 40 40.0
Criner $3.3 3.3 $50 53.3
Total $80 $83.3 $133.3
Capital of $80 at the start, increases by the $3.3
goodwill and the $50 cash investment.

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 Invest in Business: Bonus
Andrew and Boyles decide not to revalue the
business assets, and Criner invests $50 cash in
the business for a 1/3 interest.
Before Investment Bonus Final
Andrew $50 ($1) $49
Boyles 40 (1) 39
Criner $50 2 52
Total $90 $130
Criner's new capital = 1/3 of the total $130. Since
he invests on $50 cash for a $52 interest, the $2
bonus is transferred from the old partners.
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 Entries for Investment in Business
Entries for Criner's investment, under goodwill
and bonus methods:
Goodwill 20
Andrew Capital 10
Boyles Capital 10
Cash 60
Criner Capital 60
Goodwill method, goodwill to old partners
Cash 50
Andrew Capital 1
Boyles Capital 1
Criner Capital 52
Bonus method, bonus to new partner
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Partnerships – Formation, Operations, and Changes in
Ownership Interests
5: Death or Retirement of a Partner

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 Dissociation
Firm value, according to RUPA, is the greater of
– Liquidation value
– Sales value as a going concern without the
dissociated partner
Payment to exiting partner is
– Equal to existing capital
– More than existing capital
• Implied goodwill or bonus to exiting partner
– Less than existing capital
• Write down overvalued assets, or bonus to
remaining partners
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Partnerships – Formation, Operations, and Changes in
Ownership Interests
6: Limited Liability Partnership

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 Limited Partnerships
Limited partnerships must have one or more
general partners
Limited partner
– Excluded from participating in management
– Limited liability
– Partnership agreement
• In writing, signed and filed

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