15
Partnerships:
Formation,
Operation, and
Changes
in Membership
McGraw-Hill/Irwin
Copyright © 2009 The McGraw-Hill Companies, Inc. All rights reserved.
Overview
•
Accounting for partnerships requires
recognition of several important factors
– From an accounting viewpoint, the partnership
is a separate business entity
– Accrual accounting, cash basis accounting, or
modified cash basis of accounting are allowed
15-2
Nature of Partnership Entity
•
Legal regulation
– Each state regulates the partnerships that are
formed in it
– Each state tends to begin with a model act
and then modifies it to fit that state’s business
culture and history
– Most states have now adopted the Uniform
Partnership Act of 1997 (UPA 1997) as the
model act
15-3
Nature of Partnership Entity
•
Definition of a partnership
– Section 202 of the UPA 1997 states that, “. . .
the association of two or more persons to
carry on as co-owners of a business for profit
forms a partnership . . .”
15-4
Nature of Partnership Entity
•
Definition of a partnership
–
–
–
Association of two or more persons – The “persons”
may be individuals, corporations or other partnerships
To carry on as co-owners – Each partner has the
apparent authority, unless restricted by the partnership
agreement, to act as an agent of the partnership for
transactions in the ordinary course of business
Business for profit – The partnership must attempt to
make a profit; therefore, not-for-profit entities, such as
fraternal groups, may not organize as partnerships
15-5
Nature of Partnership Entity
•
Formation of a partnership
– Easy to form
– The agreement to form a partnership may be
informal or formal
– Each partner must agree to the formation
agreement, and partners are strongly advised
to have a formal written agreement to avoid
potential problems later
15-6
Nature of Partnership Entity
•
Other major characteristics
– Partnership agreement: The UPA 1997 is
used by the courts when there is no
partnership agreement
– Partnership as a separate entity: The entity
concept means that a partnership can sue or
be sued and that partnership property belongs
to the partnership and not to any individual
partner
15-7
Nature of Partnership Entity
•
Other major characteristics
– Partner is an agent of the partnership: The
agency relationship among the partners is
very important
– Statement of partnership authority: Describes
the partnership and identifies the specific
authority of partners to transact
15-8
Nature of Partnership Entity
•
Other major characteristics
– Partner’s liability is joint and several: All
partners are liable jointly and severally for all
obligations of the partnership unless otherwise
provided by law
– Partner’s rights and duties: Each partner is to
have a capital account presenting the amount
of that partner’s contributions to the
partnership, net of any liabilities, and the
partner’s share of the partnership profits or
losses, less any distributions
15-9
Nature of Partnership Entity
•
Other major characteristics
– Partner’s transferable interest in the
partnership: A partner is not a co-owner of any
partnership property
– Partner’s dissociation: A partner’s dissociation
means that the partner can no longer act on
behalf of the partnership
15-10
Nature of Partnership Entity
•
Types of limited partnerships
– Limited Partnerships (LP)
•
•
•
There is at least one general partner and one or
more limited partners
The general partner is personally liable for the
obligations of the partnership and has
management responsibility
Limited partners are liable only to the extent of
their capital contribution but do not have any
management authority
15-11
Nature of Partnership Entity
•
Types of limited partnerships
– Limited Liability Partnerships (LLP)
•
•
•
One in which each partner has some degree of
liability shield
There are no general or limited partners
Each partner has the rights and duties of a
general partner, but limited legal liability
15-12
Nature of Partnership Entity
•
Types of limited partnerships
– Limited Liability Limited Partnership (LLLP)
•
•
Each partner is liable only for the business
obligations of the partnership, and not for acts of
malpractice by the other partners in the normal
course of the partnership’s business
General partners, even though responsible for
management of the partnership, have no
personal liability for partnership obligations
15-13
Nature of Partnership Entity
•
Accounting and financial reporting
requirements for partnerships
– For internal reporting needs, non-GAAP
accounting methods may be used and
financial reports may be in a format different
from those required under GAAP
– To issue general-purpose financial statements
for external users, generally accepted
accounting principles should be used
15-14
Accounting for the Formation of a
Partnership
•
At the formation of a partnership:
– Assign a proper value to the noncash assets
and liabilities contributed
– Distinguish between capital contributions and
loans made to the partnership by individual
partners
– Distinguish between tangible assets owned by
the partnership and those specific assets that
are owned by individual partners but are used
by the partnership
15-15
Accounting for the Formation of a
Partnership
•
•
FASB Statement No. 157: Contributed
assets should be valued at their fair values,
which may require appraisals or other
valuation techniques
Liabilities assumed by the partnership
should be valued at the present value of the
remaining cash flows
15-16
Accounting for the Formation of a
Partnership
•
•
The individual partners must agree to the
percentage of equity that each will have in
the net assets of the partnership
Generally, the capital balance is determined
by the proportionate share of each partner’s
capital contribution
15-17
Accounting for Operations of a
Partnership
•
Partners’ accounts
– Capital accounts
•
•
Used to record the initial investment of a partner,
any subsequent capital contributions, profit or
loss distributions, and any withdrawals of capital
by the partner
Deficiencies are usually eliminated by additional
capital contributions
15-18
Accounting for Operations of a
Partnership
•
Partners’ accounts
– Drawing accounts
•
•
Used to record periodic withdrawals and is then
closed to the partner’s capital account at the end
of the period
Noncash drawings are valued at their market
values at the date of the withdrawal
– Loan accounts
•
•
A loan from a partner is shown as a payable on
the partnership’s books
Unless all partners agree otherwise, the
partnership is obligated to pay interest on the
loan
15-19
Allocating Profit or Loss to Partners
•
•
•
Profit or loss is allocated to the partners at
the end of each period in accordance with
the partnership agreement
If no agreement exists, all partners are to
share profits and losses equally (UPA 1997)
Profit distribution plans
–
–
–
–
Preselected ratio
Interest on capital balances
Salaries to partners
Bonuses to partners
15-20
Allocating Profit or Loss to Partners
•
•
The profit or loss distribution is recorded
with a closing entry at the end of each
period
The revenue and expenses are closed into
an income summary account or directly into
the partners’ capital accounts
15-21
Allocating Profit or Loss to Partners
•
Multiple bases of profit allocation
– A combination of several allocation
procedures:
Example: (AB Partnership)
•
•
•
•
Interest of 15 percent on weighted-average capital balances.
Salaries of $2,000 for A and $5,000 for B.
A bonus of 10 percent to be paid to B on partnership income exceeding
$5,000 before subtracting the bonus, partners’ salaries, and interest on
capital balances.
Any residual to be allocated in the ratio of 60 percent to A and 40 percent
to B.
– Agreement should have a provision to specify
the allocation process in a deficiency situation
15-22
Partnership Financial Statements
•
In addition to the three basic financial
statements, a statement of partners’ capital
is prepared to present the changes in the
partners’ capital accounts for the period
15-23
Changes in Membership
•
New partners are often a source of
additional capital or business expertise
– Admission of a new partner is subject to the
unanimous approval of the present partners
– Public announcements are typically made
– A new partner is not personally liable for any
partnership obligation incurred prior to
admission
15-24
Changes in Membership
•
Retirement or withdrawal of a partner from a
partnership is a dissociation of that partner
– This does not necessarily mean a dissolution
and winding up of the partnership
– The partnership may purchase the dissociated
partner’s interest at a buyout price
– Partners who simply wish to leave may be
liable to the partnership for damages caused
by a wrongful dissociation
15-25
Changes in Membership –
General concepts
•
The partnership as an entity separate from
the individual partners and the use of GAAP
– The partnership entity does not change
because of the addition or withdrawal
– A partnership following GAAP and defining its
company as an entity separate from the
individual partners would account for a
change in membership in the same manner as
a corporate entity would account for changes
in its investors
15-26
Changes in Membership –
General concepts
•
Recognizing decreases in net asset revaluations
–
–
–
–
FASB 142 presents procedures for recognizing
impairments of currently held goodwill
FASB 144 presents the accounting standards for
recognizing impairment losses on long-lived assets
Net asset revaluations performed using the
appropriate accounting standards are in accordance
with GAAP
There are no GAAP standards that provide for
increases in the value of nonfinancial assets or
recognition of new goodwill, solely due to a change in
membership
15-27
Changes in Membership –
General concepts
•
Bonus method
– Records an increase in the partnership’s total
capital only for the capital amount invested by
the new partner, in accordance with GAAP
– The method assigns partners’ capitals based
on the agreement of the partners, and it is
often based on the value of the new partner’s
investment
– It does not violate GAAP
15-28
Changes in Membership –
General concepts
•
The partnership as an aggregate of
partners’ interests and the use of nonGAAP accounting
– Partners may use non-GAAP accounting
methods that meet their information needs
15-29
Changes in Membership –
General concepts
•
Recognizing increases in net asset
revaluations or goodwill
– Recognizing increases in a partnership’s net
assets using the net asset revaluation
method, or recognizing previously unrecorded
goodwill using the goodwill recognition
method, are not in compliance with GAAP
15-30
New Partner Invests in Partnership
•
Step 1: The first step is to compute the new
partner’s proportion of the partnership’s
book value:
15-31
New Partner Invests in Partnership
•
Step 2: Determine the specific admission
method
– Methods used if a difference exists between
the new partner’s investment and his or her
proportion of the partnership’s book value:
•
•
•
Revalue net assets
Recognize goodwill
Use the bonus method
15-32
New Partner Invests in Partnership
Overview of Accounting for Admission of a New Partner
15-33
New Partner Invests in Partnership
•
Determining a new partner’s investment
cost
– It is important to note the total resulting capital
of the partnership and the percentage of
ownership interest retained by the prior
partners
15-34
Dissociation of a Partner
•
•
In most cases, the partnership purchases
the dissociated partner’s interest in the
partnership for a buyout price
The buyout price is the estimated amount if:
– The partnership assets were sold at a price
equal to the greater of the liquidation value or
the value based on a sale of the entire
business as a going concern without the
dissociated partner, and
– The partnership was wound up at that time,
with all partnership obligations settled
15-35
Dissociation of a Partner
– Goodwill may be included in the valuation
– The partnership must pay interest to the
dissociated partner from the date of
dissociation to the date of payment
– In cases of wrongful dissociation, the
partnership may sue the partner for damages
the wrongful dissociation causes the
partnership
15-36
Dissociation of a Partner
•
Buyout price equal to partner’s capital credit
– If the partnership is unable to pay the amount
at the time of retirement, it must recognize a
liability for the remaining portion
15-37
Dissociation of a Partner
•
Buyout price greater than partner’s capital credit
–
–
Most partnerships would account for the payment
above the dissociating partner’s capital credit as a
capital adjustment bonus to the partner from the
capital accounts of the remaining partners
Occasionally, a partnership uses the retirement of a
partner to record unrecognized goodwill
•
The partnership may record the retiring partner’s share
only, or it may impute the entire amount of goodwill based
on the retiring partner’s profit percentage
15-38
Dissociation of a Partner
•
Buyout price less than partner’s capital
credit
– Results if liquidation values of net assets are
less than their book values or because the
dissociating partner wishes to leave the
partnership badly enough
– The partnership should evaluate its net assets
to determine impairments or write-downs
– If no revaluations are necessary, the
difference is distributed as a capital
adjustment to remaining partners in their
respective profit and loss ratio
15-39