Advanced Accounting B Partnership Accounting: Basic Concepts Page 1 PARTNERSHIP ACCOUNTING

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1 Advanced Accounting B Partnership Accounting: Basic Concepts Page 1 I. Basic Concepts of Partnership Accounting PARTNERSHIP ACCOUNTING A. What is A Partnership?: An association of two or more persons to carry on as co-owners of a business for a profit; the basic rules of partnerships were defined by Congress: 1. Uniform Partnership Act of 1914 (general partnerships) 2. Uniform Limited Partnership Act of 1916 (limited partnerships) B. Characteristics of a Partnership: 1. Limited Life--dissolved by death, retirement, incapacity, bankruptcy etc 2. Mutual agency--partners are bound by each others acts 3. Unlimited Liability of the partners--the partnership is not a legal or taxable entity and therefore all debts and legal matters are the responsibility of the partners. 4. Co-ownership of partnership assets--all assets contributed to the partnership are owned by the individual partners in accordance with the terms of the partnership agreement; or equally if no agreement exists. C. The Partnership Agreement: A contract (oral or written) which can be used to modify the general partnership rules; partnership agreements at a minimum should cover the following: 1. Names or Partners and Partnership; 2. Effective date of the partnership contract and date of termination if applicable; 3. Nature of the business; 4. Place of business operations; 5. Amount of each partners capital and the valuation of each asset contributed and date the valuation was made; 6. Rights and responsibilities of each partner; 7. Dates of partnership accounting period; minimum capital investments for each partner and methods of determining equity balances (average, weighted average, year-end etc.) 8. A formula for the distribution of Net Income to each partner; 9. Rules regarding Drawing of Capital by partners; penalties violation of drawing agreements; 10. Procedures in the event of death, retirement or incapacity of partners; 11. Provision for arbitration of disputes 12. Rights and responsibilities upon dissolution and penalties for failing to comply; II. Partnership accounting Overview: A. Accounting for partnerships covers three primary areas: 1. Formation and operation of the partnership 2. Changes in partnership equity subsequent to formation 3. Partnership liquidations III. FORMATION AND OPERATION OF THE PARTNERSHIP A. Opening the books: Assets (at FMV)... xxxx Liabilities (book value)... xxxx Capital... xxxx te: Assets should be recorded at FMV at date of partnership organization because gains and losses on asset disposal will be partnership gains and losses and allocated in accordance with the partnership agreement or profit and loss ratio. Assets not recorded at FMV can result in inequities. To illustrate possible inequities created when assets are not valued at FMV upon contribution to the firm, consider the following example: EXAMPLE: -- A & B form the AB partnership. -- "A" contributes land with a cost basis of $5,000 and a FMV of $10, "B" contributes cash of $10, The land is sold immediately for $10,000. Case #1: Land recorded at $5,000 Case #2: Land recorded at $10,000 "A" Capital "B" Capital "A" Capital "B" Capital Beginning Capital... $ 5,000 $ 10,000 $ 10,000 $ 10,000 Gain on sale of land. 2,500 2, Ending Capital... $ 7,500 $ 12,500 $ 10,000 $ 10,000

2 Advanced Accounting B Partnership Accounting: Basic Concepts Page 2 B. Distribution of net income 1. net income may be distributed IAW with any method but the most common are: a. specified ratio (IAW partnership agreement) b. service contributed by partner c. relative investments 2. common factors often found in a partnership agreement regarding the distribution of partnership net income are: EXAMPLE; a. interest of capital (a reward for leaving capital in the partnership, not an expense) b. salary (a reward for services rendered to the partnership, not an expense) c. profit and loss ratio 1. anything agreed to by the partners 2. assumes that losses are shared in the same ratio as profits unless specified otherwise 3. To illustrate the distribution of partnership income/loss IAW the partnership agreement, consider the following facts: -- A,B, and C form a partnership and at the end of the year have the following balances: A B C Beginning Capital... $ 45,000 $ 34,000 $ 25,000 Drawing... 5,000 4,000 5,000 Ending Capital... $ 40,000 $ 30,000 $ 20,000 The partnership agreement specifies the following: 1. Interest on EOY capital to be 7% 2. Salary 6k,8k,10k, respectively 3. profit and loss to be shared equally. NOTE: SALARY IS SEPARATE FROM THE DRAWING ACCOUNT NOTE THAT INTEREST AND SALARIES ARE DISTRIBUTIONS OF NET INCOME AND NOT EXPENSES OF THE REQUIRED: 1. What is the capital ratio at EOY? 2. Prepare a schedule reflecting the distribution of net income under each of the following independent assumptions: Assumption a. NI= $51,300 b. NI= $21,300 c. NI= $<4,500> d. NI= $0 3. Present the closing entry required on the partnership books at EOY to reflect the distribution of net income to the partners for case 2a above. Solution: 1. 4:3:2 2a. (NI=$51,300) A B C Total Interest on capital... $ 2,800 $ 2,100 $ 1,400 $ 6,300 Salary... 6,000 8,000 10,000 24,000 Hypothetical distr... 8,800 10,100 11,400 30,300 Excess IAW P/L ratio.. 7,000 7,000 7,000 21,000 Actual distribution... $15,800 $17,100 $18,400 $51,300 2b. (NI=$21,300) Interest on capital... $ 2,800 $ 2,100 $ 1,400 $ 6,300 Salary... 6,000 8,000 10,000 24,000 Hypothetical distr... 8,800 10,100 11,400 30,300 Excess IAW P/L ratio.. <3,000> <3,000> <3,000> <9,000> Actual distribution... $ 5,800 $ 7,100 $ 8,400 $21,300 2c. (NI=$<4,500>) Interest on capital... $ 2,800 $ 2,100 $ 1,400 $ 6,300 Salary... 6,000 8,000 10,000 24,000 Hypothetical distr... 8,800 10,100 11,400 30,300 Excess IAW P/L ratio.<11,600> <11,600> <11,600> <34,800> Actual distribution... $<2,800> $<1,500> $< 200> $<4,500>

3 Advanced Accounting B Partnership Accounting: Basic Concepts Page 3 2d. (NI=$0) Interest on capital... $ 2,800 $ 2,100 $ 1,400 $ 6,300 Salary... 6,000 8,000 10,000 24,000 Hypothetical distr... 8,800 10,100 11,400 30,300 Excess IAW P/L ratio. <10,100> <10,100> <10,100> <30,300> Actual distribution... $<1,300> $ -0- $ 1,300 $ Income summary "A" Capital... 15,800 "B" Capital... 17,100 "C" Capital... 18,400 C. Computation of Interest on Capital 1. You may be asked to compute interest on capital based on BOY, EOY or average capital balances. BOY and EOY are self explanatory, but the weighted average balance computation is more involved. Average Capital Balance = Net Capital Balance x time balance was unchanged = (Capital Drawing) x time balance was unchanged This computation results in a weighted average. EXAMPLE: WTD "A" Capital: Date Change Balance Time AVG 1/1 $10,000 1/12 $ 833 2/1 <100> 9,900 6/12 4,950 8/1 <500> 9,400 1/ /1 2,000 11,400 2/12 1,900 11/1 <200> 11,200 2/12 1,867 12/12 $ 10,333 te: For those of you studying for the CPA examination, this is the same approach as computing weighted average number of shares in an EPS problem D. Bonus to a Partner 1. A bonus is a means of rewarding a partner for meeting specified requirements. It is different than salary, but like salary it is not an expense. However, for computational purposes only, the partners may elect to treat the bonus as an expense i.e. the bonus will be computed based net income after bonus. Bonus is computed as follows: a. Bonus not treated as an expense: BONUS = BONUS % x PARTNERSHIP INCOME b. Bonus treated as an expense: BONUS = BONUS % (PARTNERSHIP INCOME - BONUS) EXAMPLE: --A and B are partners and agree that "A" is to receive a bonus of 20% of partnership income if the partnership has net income in excess of $40,000 per year. --The P/L ratio is 50:50 and NI=$50,000 this year. The distribution of net income would be as follows: a. Bonus not treated as an expense: A B Total Bonus to "A" 10,000 10,000 Balance IAW P/L ratio 20,000 20,000 40,000 Actual distribution 30,000 20,000 50,000 ** Let Bonus = X then X =.2(50,000 - X) = 10, X b. Bonus treated as an expense: Bonus to "A" ** 8,333 8,333 = 8,333 Balance IAW P/L ratio 20,833 20,833 41,667 Actual distribution 29,167 20,833 50,000

4 Advanced Accounting B Partnership Accounting: Basic Concepts Page 4 E. Changes in Partnership P/L Ratios During the Acct Period 1. When a partnership changes the P/L ratios, corrections of prior years income and distributions of non-operating gains and losses should be made using the P/L ratios in effect when the revenue was earned or the asset acquired. Example: The XY partnership acquired land at a cost of $100,000 when the P/L ratio was 60/40. The following year, the P/L ratio was changed to 70/30. At that time the FMV of the land was $140,000. The asset was sold for $200,000 later that year. The $100,000 non-operating gain should be distributed as follows: A B Total $40,000 gain 60/ ,000 16,000 40,000 $60,000 gain 70/ ,000 18,000 60,000 NOTE: WHEN A PARTNERSHIP CHANGES THE P/L RATIO, THE FMV OF ASSETS SHOULD BE DETERMINED IN ORDER TO INSURE AN EQUITABLE DISTRIBUTION OF THE GAIN OR LOSS AT THE TIME OF ASSET LIQUIDATION.

5 Advanced Accounting B Partnership Accounting: Basic Concepts Page 5 IV. CHANGES IN OWNERSHIP EQUITY Purchase ( Assets In) At Book? Rearrange Capital IAW Capital given up More than BV? Record GW? 1. Record GW IAW P/L ratio 2. Rearrange Capital Accounts IAW Capital Ratio BV Less than BV? Write Down Assets? 1. Write down assets IAW P/L ratio 2. Rearrange Capital Accounts IAW Capital Ratio BV Investment (Assets In) 1. Calculate Actual Capital (A) 2. Calculate Agreed-upon Capital (B) Does A = B? GW Situation Bonus Situation Is Investment > or < % of Actual Capital (A) to New? Is Investment > < or = to Agreed Upon Capital (B) to New Partner? > < > < = GW to Old Partners IAW P/L ratio GW to New Partner Bonus to Old in P/L ratio Bonus to New Partner Bonus = 0

6 Advanced Accounting B Partnership Accounting: Basic Concepts Page 6 V. CHANGES IN PARTNERSHIP EQUITY SUBSEQUENT TO FORMATION A. Types of partnership realignment 1. Admission of a new partner 2. Withdrawal of a partner B. Admission of a new partner 1. Two ways to gain admission: a. purchase an interest from existing partners (no new assets go into the partnership; exchanges are "off the books between the individual partners) 1. does not affect partnership assets Dr. Old capital accounts for % given up...xxx Cr. New Capital for amount purchased... xxx NOTE: Cash or other interest is transferred outside of the partnership so there is no change in total partnership capital; just a rearrangement of the capital balances. b. Investment in the partnership (Assets go into the partnership; partnership capital is increased) 1. affects partnership assets Dr. Assets added to partnership...xxx Cr. new partners capital... xxx NOTE: When reading a "problem or exercise" the word "contribution" means investment. C. The purchase method: three situations are possible 1. purchase at book value --X,Y AND Z are partners with a P/L ration of 2:3:5 --capital balances are 12k, 21k, and 27k respectively (Total=$60,000) --"P" wishes to acquire a 1/3 interest in the partnership at book value. --assume assets are fairly valued. Required: present the necessary journal entry. X capital (1/3)(12,000).. 4,000 Y capital (1/3)(21,000).. 7,000 Z capital (1/3)(27,000).. 9,000 P capital... 20,000 (1/3 of 60,000) 2. purchase at > book value --assume the same facts as above except that "P" is willing to pay $26,000 for a 1/3 interest. --If "P" is willing to pay $26,000 for a 1/3 interest, it is implied that the partnership must be worth $78,000 (3 x $26,000). Computed Total Capital (TC) = $78,000 Actual Total Capital = 60,000 Implied Goodwill... =$ 18,000 --The question now becomes whether the partnership wishes to recognize the goodwill. The recognition of goodwill traceable to the old partners is often criticized by accountants as "self-created" and therefore should not be recognized because APBO. 17 ("Intangible Assets") prohibits the recognition of goodwill unless it is purchased from an outside source. This viewpoint posits that the new partnership is merely a continuation of the old partnership and is consequently not entitled to recognize goodwill. This position notwithstanding, it is permissible to recognize partnership goodwill in this instance based on the concept that the partnership is becoming a new legal entity with the admission of a new partner. a. If GW is recognized two steps: NOTE: a. The P/L ratio has nothing to do with capital contributions b. Assets change hands outside the partnership in a purchase and does not affect the partnership assets or capital 1. Allocate GW to old partners IAW P/L ratio and debit GW 2. Put new partner on the books at the amount purchased (1) GW...18,000 X Capital (2/10 x 18,000)... 3,600 Y Capital (3/10 x 18,000)... 5,400 Z Capital (5/10 x 18,000)... 9,000 (2) X Capital (15,600 x 1/3)... 5,200 (12, ,600) Y Capital (26,400 x 1/3)... 8,800 (21, ,400) Z Capital (36,000 x 1/3)...12,000 (27, ,000) P Capital... 26,000

7 Advanced Accounting B Partnership Accounting: Basic Concepts Page 7 b. GW is not recognized 3. put new partner on books at % of actual capital; charge old partners capital accounts for percentage given up. (3) X Capital (1/3 x 12,000)...4,000 Y Capital (1/3 x 21,000)...7,000 Z Capital (1/3 x 27,000)...9,000 P Capital... 20,000 NOTE: IT IS ESSENTIAL TO ADJUST ALL ASSETS TO FMV PRIOR TO MAKING THIS ENTRY TO INSURE THAT THE NEW PARTNER IS NOT GETTING A 1/3 INTEREST FOR LESS THAN 1/3 OF THE FMV 3. Purchase at < Book Value --Assume the same facts except "P" pays $17,000 for a 1/3 interest --This implies that the value of the partnership is 3 x $17,000=$51,000 Computed TC = $51,000 Actual TC = 60,000 Negative GW = 9,000 Two possibilities exist: (a) recognize the negative goodwill -- write down the assets and charge old capital IAW existing P/L ratio [(4) below] -- adjust old partners capital IAW % given up and put new partner on the books at cost. [(5) below] (4) X Capital (.2 x 9,000)...1,800 Y Capital (.3 x 9,000)...2,700 Z Capital (.5 x 9,000)...4,500 Assets... 9,000 (5) X Capital (10,200 x 1/3)...3,400 Y Capital (18,300 x 1/3)...6,100 Z Capital (22,500 x 1/3)...7,500 P Capital... 17,000 (b) ignore the negative goodwill --adjust old partners capital IAW % given up and record at new partner at book value.[(6) below] (6) X Capital (1/3 x 12,000)...4,000 Y Capital (1/3 x 21,000)...7,000 Z Capital (1/3 x 27,000)...9,000 P Capital (1/3 x 60,000)... 20,000 D. The Investment Method (increases assets of the partnership) 1. When assets are to be contributed to the partnership, the new capital balances of each partner must be agreed to prior to making the entries. Two possibilities exist: a. (A) Actual capital = Agreed upon capital > (Bonus Situation) b. (B) Actual capital not = to Agreed upon capital---> (Goodwill Situation) (A) = Actual Capital = Old partners existing capital + new investment (B) = Agreed upon capital = Assets to be invested / new partners % (use this formula as long as (B) computes > or = (A) NOTE: (B) MUST be > or = to (A); if it is < (A) then use the following formula to compute (B); If it is not, you MUST USE THE ALTERNATIVE FORMULA!!!! Alternative formula: Old partners existing capital / 1-new partners % (This adjustment is necessary to prevent recognition of negative goodwill and the required write-down of assets unless specifically called for in the facts of the problem.)

8 Advanced Accounting B Partnership Accounting: Basic Concepts Page 8 VI. CHANGES IN OWNERSHIP EQUITY--ILLUSTRATIVE EXAMPLES 1. (Bonus = 0) --A,B and C are partners with capital balances of 20k, 30k, and 40k respectively. Present the necessary analysis and journal entry if A,B and C allow D to invest $30,000 for a 1/4 interest. (A) = =120k (B) = 30 /.25=120k (te that this is > or = to (A)) Therefore (A)=(B) and this is a bonus situation amount invested... $30,000 new partners agreed upon capital... $30,000 Bonus Cash...30,000 D Capital... 30, Bonus to old partners --assume the same facts except that D invests $40,000 for a 1/4 interest and the partners agree that the total capital will be $130,000 (A)=90+40=$130,000 (B)=$130,000 by agreement (no computation was necessary) (A)=(B) so a bonus situation exists. "D" is paying $40,000 for an interest with a book value of $32,500 ($130,000 x.25) so the bonus is to the old partners in the amount of $7,500 and will be allocated in the P/L ratio existing just prior to the admission of "D". Cash... 40,000 A capital (7,500 x 1/3)... 2,500 B capital (7,500 x 1/3)... 2,500 C capital (7,500 x 1/3)... 2,500 D capital (130,000 x.25)... 32, Bonus to new partner --assume the same facts as situation #1 except that "D" invests $20,000 for a 1/4 interest. The partners agree in advance that the total capital of the partnership will be $110,000 after the investment. (A)=90+20 = $110,000 (B)= $110,000 by agreement (again, the computation of (B) is only necessary if the total capital is not agreed to in the problem.) (A)=(B) so a bonus situation exists. "D" is now paying $20,000 for an interest with a book value of $27,500 ($110,000 x.25) so the bonus is to the new partner in the amount of $7,500 and will be charged to the old partners capital accounts in the P/L ratio existing just prior to the admission of "D". Cash...20,000 A capital... 2,500 B capital... 2,500 C capital... 2,500 D capital... 27, Goodwill to old partners --assume the same facts as situation #1 except that "D" invests $32,000 for a 1/4 interest and no total capital figure is agreed to in advance. (A)=90+32 = $122,000 (B)= 32 /.25 = $128,000 (note this is > or = to (A)) (A) does not = (B) so a goodwill situation exists in the amount of $6,000 (128, ,000). The goodwill is to the old partners because the fair market value of the partnership implied by "D's" willingness to pay $32,000 for a 1/4 interest ($128,000) is greater than the book value of the new partnership ($122,000). Goodwill is allocated to the old partners IAW P/L ratio just prior to admission of the new partner.

9 Advanced Accounting B Partnership Accounting: Basic Concepts Page 9 Cash...32,000 Goodwill... 6,000 A capital... 2,000 B capital... 2,000 C capital... 2,000 D capital... 32, Goodwill to the new partner --assume the same facts as situation #1 except that "D" invests $24,000 for a 1/4 interest and the total capital is agreed to be $120,000. (A)=90+24 = $114,000 (B)= 120,000 agreed to in advance (A) does not = (B) so a goodwill situation exists. Goodwill is $6,000 and is attributable to the new partner because the fair market value of the of his investment agreed to by the partners of $30,000 ($120,000 x.25) is greater than the amount invested ($24,000). Cash...24,000 Goodwill... 6,000 D capital... 30,000 E. Withdrawal of a Partner 1. The withdrawal of a partner requires the partnership to determine the fair market value of the partnership and compute the income earned by the partnership up to the date of withdrawal. Assuming the partnership agreement does not specify how the withdrawal is to be handled, the same rules as admission apply and the withdrawal can result in bonus or goodwill to either the withdrawing partners or the remaining partners. Each fact situation must be read carefully to determine the desires of the partners.