Chapter Fourteen

Partnerships: Formation and

Operation

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Partnership Advantages

A partnership is defined as “an association of two or more persons to carry on a business as co-owners for profit.” (Section 6 of Uniform Partnership Act).

Flexibility in defining relationships

Profits and losses, and management operating decisions, may be shared independent of ownership percentages

Ease of formation and dissolution

Taxes “flow-through” the partnership (conduit) to the partners, and are taxed to the individuals (no double- taxation).

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Partnership Disadvantages

Unlimited liability incurred by each partner (they are “jointly and severally” liable)

Mutual agency (each partner has the right to incur liabilities in the name of the partnership)

Inability to participate in various corporate tax benefits

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Articles of Partnership

Partnerships can exist even in the absence of a written partnership agreement.

The Uniform Partnership Act establishes standards and rules for partnerships.

A written agreement will supersede the UPA standards.

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Accounting for Capital Contributions

The initial transaction is the contribution the original partners make to start the business. In the simplest situation, the partners invest only cash amounts.

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Accounting for Capital Contributions

Contributed intangible assets require special consideration.

Contributions made by one or more of the partners may go beyond assets and liabilities, for example, a particular line of expertise or established clientele.

Use either the Bonus Method or Goodwill Method for recording contributed intangible assets.

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Allocation of Income

The allocation of income is not necessarily based on the relative capital balances.

It is a separately negotiated item.

Allocated compensation

Bonuses Remaining income

Interest on beginning capital

balances

Items to be allocated:

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Allocation of Income -- Example

Assume that Tinker, Evers, and Chance form a partnership by investing cash of $120,000, $90,000, and $75,000, respectively.

Evers will be allotted 40 %of all profits and losses because of previous business experience. Tinker and Chance are to divide the remaining 60 % equally. This agreement also stipulates that each partner is allowed to withdraw $10,000 in cash annually from the business.

Net income for the period is $60,000.

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Alternative Technique-1

Assume the original facts for the Tinkers, Evers, and Chance partnership except an articles of partnership agreement credits each partner annually for interest equal to 10 % of that partner’s beginning capital balance for the year.

Evers and Chance will also be allotted $15,000 each as a compensation allowance in recognition of their participation in daily operations.

Any remaining profit or loss will be split 4:3:3, with the largest share going to Evers because of the work experience that this partner brings to the business.

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Alternative Technique- 1

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Alternative Techniques-

The assignment process is merely a series of mechanical steps reflecting the change in each partner’s capital balance resulting from the provisions of the partnership agreement.

The number of different allocation procedures that could be employed is limited solely by the partners’ imagination.

Although interest, compensation allowances, and various ratios are the predominant factors encountered in practice, numerous other possibilities exist.

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Legal Dissolution

Any alteration in the specific individuals composing a partnership results in “legal dissolution”– Departures– Retirement – Death– Admission (including promotion) of a

New Partner Frequently leads to immediate formation of

a new partnership as business continues Can lead to termination and liquidation

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These two rights can be sold (unless restricted by the

articles of partnership).

This right cannot be sold without the

other partners’ approval.

Admission of a New Partner - The Rights of a Partner

An individual partner’s ownership rights include:

The right to co-ownership in the business property.

The right to share in profits and losses as specified in the partnership agreement

The right to participate in the management of the business.

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Admission of a New Partner - Purchase of a Current Interest

A new partner can purchase partnership interest directly from the existing partners.The cash goes to the partners, not the

partnership.Two methods are available to account

for the transfer of ownership:Book Value ApproachGoodwill (Revaluation) Approach

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Admission of a New Partner - Contribution to the Partnership

The new partner can also gain partnership interest by contributing cash to the partnership.

Remember that the new cash will increase the partnership’s net assets.

Two methods are:Bonus ApproachGoodwill Approach

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Withdrawal of a Partner

The Withdrawing Partner is paid out in accordance with the Partnership Agreement.

Using the Bonus Method, any amount paid in excess of that partner’s capital account is allocated against the remaining partners’ capital accounts.

Using the Goodwill Method, the books are first adjusted to FMV, with a proportion of the increase allocated to each partner’s account. The withdrawing partner is then paid based on the balance in the individual capital account.

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