Chapter 16:

Partnerships – Formation,
Operations, and Changes in
Ownership Interests

RENNA
MAGDALENA
 Partnerships
1. Entity theory: partners own their share of the partnership,
but not its individual assets
2. Dissociation: partners can dissociate without dissolution
3. Partners have:
1. Mutual agency
2. Unlimited liability
 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
 Partnership Reporting
1. Partners
2. Creditors of the partnership
3. IRS
Initial Investment

01
 Initial Investment (Cash)
Initial investments in a partnership are recorded in capital accounts maintained for
each partner. If Ash and Bec each invest $20,000 cash in a new partnership, they
record the investments as follows:
Cash (+A) 20,000
Ash capital (+OE) * 20,000
To record Ash’s original investment of cash.

Cash (+A) 20,000

Bec capital (+OE) 20,000

,
To record Bec’s original investment of cash.

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 Initial Investment (Noncash)
for example, that Col and Cro enter into a partnership with the following
investments:

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 Initial Investment (Noncash)
After Col and Cro agree to the values assigned to the assets, they record the
investments as
follows:
Land (+A) 10,000
Building (+A) 40,000
Col capital (+OE) 50,000
To record Col’s original investment of land and building at fair value.
Cash (+A) 7,000
Inventory (+A) 35,000
Cro capital (+OE) 42,000

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To record Cro’s original investment of cash and inventory items at fair value.
 Bonus or Goodwill on Initial
A valuation problem arisesInvestments
when partners agree on relative capital interests that 3
2
are not aligned with their investments of identifiable assets.

For example, Col and Cro could agree to divide initial partnership capital equally,
even though Col contributed $50,000 in identifiable assets and Cro contributed
$42,000.

Such an agreement implies that Cro is contributing an unidentifiable asset

such as individual talent, established clientele, or banking connections to the
partnership.

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 Bonus or Goodwill on Initial
Investments 3
2
The dollar amount of the implied unidentifiable asset can be inferred from Col’s
fair-value contribution.

Col invested $50,000 of assets measured at fair value for a 50 percent interest in
the partnership. One can infer from Col’s investment that the fair value of the
partnership is $100,000 ($50,000 , 50%).

The implied fair value of the unidentifiable asset contributed by Cro is $8,000
because Cro also has a 50 percent interest in the partnership but only contributed

,
identifiable assets with a fair value of $42,000.

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 Bonus or Goodwill on Initial
Investments
The partnership agreement specifies equal capital interests, so we should adjust the 3
2
capital
account balances of Col and Cro to meet the agreement’s conditions.

Either of two approaches may be used to adjust the capital accounts—the bonus
approach or the goodwill approach. Under the bonus approach, the unidentifiable
asset is not recorded on the partnership books.

Because the total identifiable contributed capital is $92,000, each partner will start
with $46,000 if the unidentifiable asset is not recorded. As a result, Col’s capital

,
will be reduced by $4,000, and Cro’s capital will be increased by $4,000.

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 Bonus or Goodwill on Initial
Investments 3
2 Col capital (-OE)
Cro capital (+OE)
4,000
4,000
To establish equal capital interests of $46,000 by recording a $4,000 bonus from Col
to Cro.

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 Bonus or Goodwill on Initial
Investments 3
2
When the goodwill approach is used, the unidentifiable asset contributed by Cro is
measured on the basis of Col’s $50,000 investment for a 50 percent interest. Col’s
investment implies total partnership capital of $100,000 ($50,000 , 50%) and
goodwill of $8,000 ($100,000 total capital - $92,000 identifiable assets). We record
the unidentifiable asset as follows:

Goodwill (+A) 8,000

Cro capital (+OE) 8,000
To establish equal capital interests of $50,000 by recognizing Cro’s investment of

,
an $8,000 unidentifiable asset.

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ADDITIONAL INVESTMENTS AND
WITHDRAWALS

02
 ADDITIONAL INVESTMENTS
AND WITHDRAWALS 3
2
The partnership agreement should establish guidelines for additional investments
and withdrawals made after partnership operations have begun. Additional
investments are credited to the investing partner’s capital account at fair value at the
time of the investment. Withdrawals of large and irregular amounts are ordinarily
recorded directly in the withdrawing partner’s capital account. The entry for such a
withdrawal is:

Sam capital (-OE) 20,000

Cash (-A) 20,000

,
To record the withdrawal of cash.

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 Drawings
3
2 Partnership profits are the business rewards for partners, so partners do not have
take-home pay as do the employees of the partnership business.

Instead, active partners commonly withdraw regular amounts of money on a weekly

or monthly basis in anticipation of their share of partnership profits.

Such withdrawals are called drawings, drawing allowances, or sometimes salary

allowances, and they are usually recorded in the partners’ drawing accounts rather

,
than directly in the capital accounts.

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 Drawings
3
2
For example, if Tow and Lee withdraw $1,000 from the partnership each month,
they
would record the monthly withdrawals as follows:

Tow drawing (-OE) 1,000

Cash (-A) 1,000
To record Tow’s drawing allowance for January.
Lee drawing (-OE) 1,000
Cash (-A) 1,000

,
To record Lee’s drawing allowance for January.

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 Drawings (Closing Journal)
3
2
If Tow draws $1,000 each month during the year, his drawing account balance at
year-end is
$12,000, and his drawing account is closed by the following entry:

Tow capital (-OE) 12,000

Tow drawing (+OE) 12,000
To close Tow’s drawing account.

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pARTNERSHIp
OpERATIONS

03
 Partnership Operation
Partnership general-purpose financial statements include an income statement, a 3
2
balance sheet, a statement of partnership capital, and a statement of cash flows.
The statement of partnership capital is unique to the partnership form of
organization.
Assume that Rat and Yan are partners sharing profits in a 60:40 ratio, respectively.
Data relevant to the partnership’s equity accounts for 2016 are:

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 3
2

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 3
2

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 Partnership Operation (Closing)
Closing entries for the Rat and Yan partnership at December 31, 2016, are as
follows:
3
December 31, 2016
Income summary (-OE) 34,500
Rat capital (+OE) 20,700
Yan capital (+OE) 13,800
To divide net income 60% to Rat and 40% to Yan.
December 31, 2016
Rat capital (-OE) 6,000
Yan capital (-OE) 9,000

,
Rat drawing (+OE) 6,000

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Yan drawing (+OE) 9,000
To close partner drawing accounts to capital accounts.
Sharing Profit and Loss - Agreement

03
 Sharing Profit and Loss -
Agreement 3
2 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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 Sharing Profit and Loss -
Assume that Ann, Gar, andAgreement
Kat’s partnership agreement provides that Ann and Gar
receive salary allowances of $12,000 each, with the remaining income allocated
3
2 equally among the three partners. If partnership net income is $60,000 for 2016 and
$12,000 for 2017

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 Sharing Profit and Loss -
Assume that Ann, Gar, andAgreement
Kat’s partnership agreement provides that Ann and Gar
receive salary allowances of $12,000 each, with the remaining income allocated
3
2 equally among the three partners. If partnership net income is $60,000 for 2016 and
$12,000 for 2017

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 Sharing Profit and Loss -
Agreement
Journal entries to distribute partnership income to individual capital accounts for 3
2
2016 and 2017 follow:
December 31, 2016
Income summary (-OE) 60,000
Ann capital (+OE) 24,000
Gar capital (+OE) 24,000
Kat capital (+OE) 12,000
Partnership income allocation for 2016.
December 31, 2017
Income summary (-OE) 12,000

,
Kat capital (-OE) 4,000

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Ann capital (+OE) 8,000
Gar capital (+OE) 8,000
Partnership income allocation for 2017.
 BONUS AND SALARY
ALLOWANCES
Assume that the partnership agreement of Ann, Gar, and Kat provides that Ann 3
2
receive a bonus of 10 percent of partnership net income for managing the business;
that Ann and Gar receive salary allowances of $10,000 and $8,000, respectively, for
services rendered; and that the remaining partnership income be divided equally
among the three partners. If partnership net income is $60,000 in 2016 and $12,000
in 2017, the partnership income allocated

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Assume that the partnership agreement of Ann, Gar, and Kat provides that Ann
receive a bonus of 10 percent of partnership net income for managing the business;
that Ann and Gar receive salary allowances of $10,000 and $8,000, respectively, for
services rendered; and that the remaining partnership income be divided equally
among the three partners. If partnership net income is $60,000 in 2016 and $12,000
in 2017, the partnership income allocated
3
2

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Assume that the partnership agreement of Ann, Gar, and Kat provides that Ann
receive a bonus of 10 percent of partnership net income for managing the business;
that Ann and Gar receive salary allowances of $10,000 and $8,000, respectively, for
services rendered; and that the remaining partnership income be divided equally
among the three partners. If partnership net income is $60,000 in 2016 and $12,000
in 2017, the partnership income allocated
3
2

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capital as a Factor in profit-Sharing Agreements

04
 INCOME ALLOCATED IN
RELATION TO PARTNERSHIP
CAPITAL
The partnership of Ace and Soy was formed on January 1, 2016, with each partner 3
2
investing $20,000 cash. Changes in the capital accounts during 2016 are
summarized as follows:

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Let’s extend the Ace and Soy example by assuming that partnership net income is
allocated on
the basis of capital balances and that net income for 2016 is $100,000. Allocation of
partnership
income to Ace and Soy under each of the three capital bases is as follows:
 INTEREST ALLOWANCES ON
PARTNERSHIP CAPITAL 3
2
An agreement may provide for interest allowances on partnership capital in
order to encourage capital investments, as well as salary allowances to
recognize time devoted to the business.

Remaining profits are then divided equally or in any other ratio specified in
the profit-sharing agreement.

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 INTEREST ALLOWANCES ON
PARTNERSHIP CAPITAL
Consider the following information relating to the capital and drawing accounts of
3
2 the Rus and Nag partnership for the calendar year 2016 (amounts in thousands):

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 INTEREST ALLOWANCES ON
PARTNERSHIP
The average
thousands):
capital balances for Rus and Nag are CAPITAL
computed as follows (amounts in 3
2

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 INTEREST ALLOWANCES ON
PARTNERSHIP CAPITAL 3
2 The partnership agreement provides
that the partnership income is
divided equally after salary
allowances of $12,000 per year for
each partner and after interest
allowances at a 10 percent annual

,
rate on average capital balances.

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 INTEREST ALLOWANCES ON
PARTNERSHIP CAPITAL 3
2

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cHANGES IN pARTNERSHIp INTERESTS

05
 Dissociation
3
2 a partner has the power to dissociate from the partnership at any time.
Dissociation is the change in relationship caused by a partner ceasing to be
associated with the carrying on of the business.

The dissociation of the partner always results in either a buyout of the dissociated
partner’s interest or a dissolution and winding up of the business.

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 Kasus :
Assignment of an Interest to a Third party
A partnership is not dissolved when a partner assigns his or her interest in the
3
2
partnership to a third party, because such an assignment does not in itself change the
relationship of the partners.
Such assignment only entitles the assignee to receive the assigning partner’s interest
in future partnership profits and in partnership assets in the event of liquidation.
The assignee does not become a partner and does not obtain the right to share in
management of the partnership.
Because the assignee does not become a partner, the only change required on the
partnership books is to transfer the capital interest of the assignor partner to his or
her assignee.

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 Assignment of an Interest to a
Third party 3
We record the assignment by Mar to Sut of his 25 percent interest in the Hall–Mar
partnership as follows:

Mar capital (-OE) 50,000

Sut capital (+OE) 50,000

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 Admission of a New partner
A person may become a partner in an existing partnership with the consent of
3
all continuing partners by purchasing an interest from one or more of the existing
partners, or by investing money or other resources in the partnership.

Partnership admission can vary widely, from the simplest case of a single new
partner entering into an existing and continuing partnership, to one multi-partner
entity joining with another multipartner entity.

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puRcHASE OF AN INTEREST FROM ExISTING
pARTNERS

06
 Admission of a New partner
For example, Alf and Bal are partners with capital balances of $50,000 each, and
they share
profits and losses equally. Cob purchases one-half of Alf’s interest from Alf for
3
$25,000, and a new partnership of Alf, Bal, and Cob is formed such that Alf and
Cob each have a 25 percent interest in the capital and profits of the new partnership.
Bal’s 50 percent interest is unchanged. The only entry required to record Alf’s
transfer to Cob is:

Alf capital (-OE) 25,000

Cob capital (+OE) 25,000
(To record Cob’s admission into the partnership with the purchase of one-half of

,
Alf’s interest.)

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 Admission of a New partner
3
Now assume that Alf and Bal have capital balances of $50,000 and $40,000,
respectively, that
they share profits equally, and that they agree to take Cob into the partnership with a
payment of $25,000 directly to Alf.

The partners may agree that half of Alf’s capital balance is to be transferred to Cob
(as in the previous example), that the net assets are not to be revalued, and that
future profits will be shared 25 percent, 50 percent, and 25 percent to Alf, Bal, and
Cob, respectively.

Although it seems equitable, there is no compelling reason for such an agreement,

because the capital and income interests were not aligned either before or after the

,
admission of Cob.

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 Admission of a New partner
3

If revaluation is desirable, the assets’ fair values should be based on appraisals or

,
evidence other than the amount of Cob’s payment to Alf.

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 Revaluation: Goodwill Approach
3
A third possibility is that Alf and Bal have capital balances of $50,000 and $40,000,
respectively, that they share profits equally, and that Cob is admitted to the
partnership with a total payment of $50,000 directly to the partners.

Cob is to have a 50 percent interest in the capital and income of the new
partnership. Alf and Bal will each have a 25 percent interest in future income of the
partnership.

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 Revaluation: Goodwill Approach
Several additional questions of fairness arise concerning the valuation of total
partnership assets, the capital transfers to Cob, and the division of the $50,000
3
payment between Alf and Bal. Cob’s $50,000 payment for a 50 percent interest in
both capital and future income implies a $100,000 valuation for total partnership
assets. If assets are to be revalued, the revaluation should be recorded prior to Cob’s
admission to the partnership. The partnership would record the revaluation as
follows:

Goodwill (or identifiable net assets) (+A) 10,000

Alf capital (+OE) 5,000

,
Bal capital (+OE) 5,000

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 Revaluation: Goodwill Approach
The previous entry recording goodwill of $10,000 gives Alf and Bal capital balances of
$55,000 and $45,000, respectively. If equal amounts of capital are to be transferred to
3
Cob, the entry to record
Cob’s admission to the partnership is:

Alf capital (-OE) 25,000

Bal capital (-OE) 25,000
Cob capital (+OE) 50,000

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 Revaluation: Goodwill Approach
Alternatively, it may be desirable to realign the capital balances of Alf and Bal in the new
partnership
such that each will have a 25 percent interest in the capital and income of the new
3
partnership.
In this case, the partnership would record the admission of Cob as follows:
Alf capital (-OE) 30,000
Bal capital (-OE) 20,000
Cob capital (+OE) 50,000

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 Nonrevaluation: Bonus Approach
3
If the assets of the new partnership are not to be revalued, but equal amounts of capital are
to be
transferred to Cob, the entry to record the transfer is:

Alf capital (-OE) 22,500

Bal capital (-OE) 22,500
Cob capital (+OE) 45,000

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 Nonrevaluation: Bonus Approach
3
Alf and Bal transfer equal amounts of capital and equal rights to future income to Cob, so
each
receiving $25,000 cash from Cob seems equitable. Each of the old partners receives $2,500
in excess
of the amount of book capital transferred ($25,000 received less $22,500 capital
transferred). The
capital accounts before and after the admission of Cob are as follows:

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 Nonrevaluation: Bonus Approach
Should Alf and Bal desire that their recorded capital and income interests in the new
partnership
are equal (that is, 25%), Alf would receive $30,000 of the amount paid by Cob, and Bal
3
would
receive $20,000. The entry to record the capital transfer in that case would be:

Alf capital (-OE) 27,500

Bal capital (-OE) 17,500
Cob capital (+OE) 45,000

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 Nonrevaluation: Bonus Approach
3

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INVESTING IN AN ExISTING pARTNERSHIp

07
 partnership Investment at Book
3
Dre and Boy have capital balances of $40,000 each and share profits equally. They agree to
admit
Value
Cry to a one-third interest in capital and profits of a new Dre, Boy, and Cry partnership for a
$40,000 cash investment. Cry’s $40,000 investment is equal to the capital interest that she
receives
[($80,000 + $40,000)/3], so the issue of revaluation does not arise.

Cry’s investment is recorded on the partnership books as follows:

Cash (+A) 40,000
Cry capital (+OE) 40,000
To record Cry’s $40,000 cash investment for a one-third interest in partnership capital and
income.

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 partnership Assets Revalued
(Goodwill to Old partners)
Now assume that Dre and Boy, who have capital balances of $40,000 each and 3
share profits equally, agree to admit Cry to a one-third interest in the capital and
profits of a new partnership for a cash investment of $50,000. Because Cry is
willing to invest $50,000 for a one-third interest in the $80,000 recorded assets
plus her $50,000 investment ($130,000 assets), the implication is that the old
partnership had unrecorded asset values. The fair value of unrecorded assets is
determined by referring to Cry’s investment. By implication, the fair value of the
new partnership’s assets is $150,000 ($50,000 , 1/3). The fair value of unrecorded
assets is $20,000, the excess of the $150,000 total value less the $80,000 recorded

,
assets plus the $50,000 new investment..

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 partnership Assets Revalued
(Goodwill to Old partners) 3
If the assets contributed by the old partnership are revalued, the following entries
are made:
Goodwill (+A) 20,000
Dre capital (+OE) 10,000
Boy capital (+OE) 10,000
To revalue the assets contributed by the old partnership based on the value of Cry’s
investment.

Cash (+A) 50,000

5
Cry capital (+OE) 50,000
To record Cry’s investment in the partnership , 7
 partnership Assets Revalued
(Goodwill to Old partners) 3

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 partnership Assets Not Revalued
(Bonus to Old partners) 3
If the partners decide against revaluation, the entry required to record Cry’s
admittance into the partnership is as follows:
Cash (+A) 50,000
Dre capital (+OE) 3,333
Boy capital (+OE) 3,333
Cry capital (+OE) 43,334
To record Cry’s investment in the partnership and to allow Dre and Boy a bonus

,
due to unrecorded asset values.

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 partnership Assets Not Revalued
(Bonus to Old partners)
This situation is referred to as a bonus to old partners because the old partners
3
receive capital credits for a part of the new partner’s investment. The capital
balances before and after the admission of Cry are as follows:

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 partnership Assets Revalued
(Goodwill to New partner)
Suppose that Dre and Boy agreed to admit Cry into the partnership for a 40
3
percent interest in the capital and profit with an investment of $50,000.
In this case, the implication is that Cry is bringing goodwill into the partnership.
That is, Dre and Boy must be willing to admit Cry to a 40 percent interest in the
$80,000 recorded assets plus her $50,000 investment (40% * $130,000 = $52,000)
because they expect Cry’s total contribution to exceed her cash investment.

Accordingly, the total value of the partnership is determined by reference to the 60

,
percent interest retained in the new partnership capital and profits by Dre and Boy.

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 partnership Assets Revalued
(Goodwill to New partner) 3
Total capital of the new partnership is $133,333 ($80,000 old capital assumed to be
fairly valued , 60%), and the partnership records the admission of Cry as follows:

Cash (+A) 50,000

Goodwill (+A) 3,333
Cry capital (+OE) 53,333

,
To admit Cry to a 40 percent interest in capital and profits.

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 partnership Assets Revalued
(Goodwill to New partner) 3

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 partnership Assets Not Revalued
(Bonus to New partner)
Under this procedure, the total assets of the new partnership are $130,000
3
($80,000 contributed by Dre and Boy plus $50,000 contributed by Cry).
Cry’s share is $52,000 ($130,000 * 0.40), but she contributed only $50,000. The
$2,000 difference between Cry’s capital credit of $52,000 and her $50,000
investment is considered a bonus to Cry.

Partnership assets are not revalued, so the excess $2,000 credited to Cry’s account
must be charged against the capital accounts of Dre and Boy in relation to their old

,
profit- and loss-sharing ratios.

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 partnership Assets Not Revalued
(Bonus to New partner)
The partnership records Cry’s admittance under the bonus procedure as follows:
3
Cash (+A) 50,000
Dre capital (-OE) 1,000
Boy capital (-OE) 1,000
Cry capital (+OE) 52,000
To record Cry’s investment of $50,000 for a 40% interest in the partnership and
allow her a $2,000 bonus..

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DISSOcIATION OF A cONTINuING pARTNERSHIp
THROuGH DEATH OR
RETIREMENT

08
 EXAMPLES
To illustrate, assume that Ann, Mic, and Jus are partners with profit- 3
2
sharing percentages of 40 percent, 20 percent, and 40 percent,
respectively, and that Jus decides to retire. The capital and income
interests of the three partners on the date of Jus’s retirement are as
follows:

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 Excess payment to Retiring
partner
The partners agree that the business is undervalued on the partnership 3
2
books and that Jus will be paid $92,000 in final settlement of his
partnership interest. The excess payment to Jus can be recorded by three
methods: (1) Jus may be granted a bonus; (2) partnership capital may be
revalued to the extent of the excess payment to Jus; or (3) partnership
capital may be revalued based on the amount implied by the excess
payment.

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 Excess payment to Retiring
partner
BONUS TO RETIRING PARTNER The partnership would record Jus’s 3
2
withdrawal as follows under the bonus procedure:
Jus capital (-OE) 80,000
Ann capital (-OE) 8,000
Mic capital (-OE) 4,000
Cash (-A) 92,000
Because Ann and Mic granted a $12,000 bonus to Jus, that amount
reduces their capital accounts using their 40:20 relative profit-sharing
ratios.

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 Excess payment to Retiring
partner 3
2
GOODWILL EQUAL TO EXCESS PAYMENT IS RECORDED A second
method of recording Jus’s withdrawal is to record the $12,000 excess of
cash paid to Jus over his capital account balance as goodwill:
Jus capital (-OE) 80,000
Goodwill (+A) 12,000
Cash (-A) 92,000
Under this approach, goodwill is recorded only to the extent paid by the
continuing partnership to Jus. This approach only provides a revaluation of

,
Jus’s share of partnership assets; it does not provide a revaluation of Ann

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and Mic’s capital interests.
 Excess payment to Retiring
partner
REVALUATION OF TOTAL PARTNERSHIP CAPITAL BASED ON EXCESS
PAYMENT A third approach for recording Jus’s retirement is to revalue total
3
2 partnership capital on the basis of the $12,000 excess payment. Under this method,
total partnership capital is revalued as follows:
Goodwill (other assets) (+A) 30,000
Ann capital (+OE) 12,000
Mic capital (+OE) 6,000
Jus capital (+OE) 12,000
The total undervaluation of the partnership is measured by the amount implied by the
excess payment. In this case, the $30,000 is computed by dividing the $12,000

,
excess payment by Jus’s 40 percent profit-sharing percentage. The partnership then

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records Jus’s retirement as follows:
Jus capital (-OE) 92,000
Cash (-A) 92,000
 payment to Retiring partner Less
than capital Balance 3
2 Suppose that Jus is paid $72,000 in final settlement of his capital interest. In this
case, the three partners may have agreed that the business is worth less than its book
value.

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 payment to Retiring partner Less
than capital Balance 3
2 OVERVALUED ASSETS WRITTEN DOWN A retirement payment to Jus of $8,000 less
than his final capital balance implies that existing partnership capital is overvalued by
$20,000 [($80,000 - $72,000) , 40%]. If the evidence available supports this implication,
the overvalued assets should be identified and reduced to their fair values. The
partnership records the revaluation and payment to Jus as follows:
Ann capital (-OE) 8,000
Mic capital (-OE) 4,000
Jus capital (-OE) 8,000

,
Net assets (-A) 20,000

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Jus capital (-OE) 72,000
Cash (-A) 72,000
 payment to Retiring partner Less
thanPARTNERS
BONUS TO CONTINUING capital Balance
If evidence indicates that partnership capital is
fairly valued, the partnership would record the retirement of Jus under the bonus
3
2 procedure as follows:
Jus capital (-OE) 80,000
Ann capital (+OE) 5,333
Mic capital (+OE) 2,667
Cash (-A) 72,000
This method of recording provides a bonus to Ann and Mic. The bonus is measured by
the excess
of Jus’s capital balance over the cash paid by the partnership for his 40 percent interest.

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THANK
YOU!