Chapter 14 Partnerships: formation
and operation
Individual proprietors often join together to form a partnership as a way to reduce
expenses, expand services, and add increased expertise (also tax benefits)
Partnership--- an association of two or more persons to carry on a business as co-owners
for profit
Doctors, lawyers, and other professionals have formed partnerships because of legal
prohibitions against the incorporation of other practices
One benefit of a partnership is the ease of formation (only an oral agreement is necessary
to create a legally binding partnership)
In contrast, a corporation requires filing a formal application and completing other forms
and documents (depending on state laws)
Another benefit of partnerships is the ability to make virtually any arrangements defining
their relationship to each other that the partners desire
Another TAX benefit of partnerships is that they are taxed on a conduit or flow-through
basis (flows through to the owners, no double taxation)
in contrast, corporations income are taxed twice—once as corporate income and again as
it is distributed to owners
another TAX advantage of partnerships is that operating losses can be used to reduce their
taxable income directly (limited though to passive activity tax laws)(whereas with
corporations, operating losses up to 80% can be carried forward for the business only)
a disadvantage of a partnership is the unlimited liability that each partner incurs (if
business fails and owes money, the person must pay it back)
alternative forms (S corps and limited partnerships *see below*) were created to limit the
owners personal liability while providing the tax benefits of a partnership
Subchapter S Corporation---- has all legal characteristics of a corporation BUT, if they
meet certain requirements, will be taxed in virtually the same way as a partnership (some
requirements include having one class of stock, 100 stockholders max)
Most significant problem of an S corp is that their growth potential is limited
Limited partnerships (LPs)---- a number of limited partners invest money as owners but
are not allowed to participate in the company’s management. Partners can still incur a
loss on their investment but amount is restricted to what was contributed.
Many LPs were originally created as tax shelters to create immediate losses with profits
spread out into the future
Limited liability partnerships (LLPs)--- has most of the characteristics of a general
partnership except partners may lose their investment in the business and are responsible
for the contractual debts of the business (advantage is avoidance of liability resulting
from damages)
Limited liability companies (LLCs)—partnership for tax purposes and court purposes,
however (depending on state laws), owners only risk their own investments. (similar to S
corp except growth is not usually restricted)
Accounting for partnerships is pretty much the same as always EXCEPT WHEN
REGARDING THE PARTNERS’ CAPITAL ACCOUNTS.
The stockholders equity accounts of a corporation don’t directly correspond with the
capital balances in a partnerships financial records. (corporations display a greater range
of info)
Partnerships only provide a limited amount of equity disclosures, primarily in the form of
individual capital accounts that are accumulated for every partner or class of partners
Thus, the equity section of a partnerships is comprised of capital accounts that can be
affected by: contributions from partners and distributions to them, earnings, and any other
equity transactions
Partnership accounting doesn’t differentiate between the sources of ownership capital
Accounting principles specific to partnerships are based primarily on traditional
approaches that have evolved over the years rather than on official pronouncements
Articles of partnership--- legal covenant, written or oral, that forms the central
governance for a partnerships operation (provide the underlying basis of partnership
accounting)
articles of partnership are a negotiated agreement- therefore millions of variations exist
articles of partnership should at least address:::: name and address of partners, business
location, description of nature of the business, rights and responsibilities of each partner,
initial contribution to be made by each partner and the method used for valuation,
specific method by which profits and losses should be allocated, periodic withdrawal of
assets by each partner, procedure for admitting new partners, method for arbitrating
partnership disputes, life insurance provisions enabling remaining partners to acquire the
interest of deceased partner, method for settling a partners share in the business upon
withdrawal retirement or death.
journal entry to record cash contributed to start a new partnership: debit cash (total), credit
*persons name*, capital (amount contributed), credit *persons name*, capital (amount
contributed)
types of equity transaction in a partnership: allocation of profits and losses, retirement of
a current partner, admission of a new partner, etc.
recording a cash investment always results in an EQUAL capital balance of the amount
invested (other assets it depends on the original book value)
each item transferred to a partnership is initially recorded for external reporting purposes
at current value
over the life of a partnership, asset valuation is important because:::: the totals in the
individual capital accounts can influence the assignment of profits and losses, the capital
account balance is usually a factor in determining the final distribution in the case of
withdrawal or retirement, and ending capital balances indicate the allocation in a case of
liquidation of the partnership
journal entry to record properties contributed to start partnership: debit cash (total of any partners
who contributed cash), debit inventory (fair value), debit land (fair value), debit building (fair
value), credit mortgage payable (balance), credit *persons name*, capital (cash invested), credit
*persons name*, capital (fair value of properties – mortgage left on building)
formal accounting recognition of a persons particular expertise or name recognition may
be appropriately included as a provision of a partnership agreement
the bonus method--- when someone has a special skill or name recognition etc, actual
contributions determine total partnership capital. (ex. James gives 70k, joyce gives 10k-
they split ownership into 40k and 40k, joyce got 30k bonus)
goodwill method--- based on assumption that an implied value can be calculated and
recorded for any intangible contribution made by a partner
journal entry to record cash contributions with goodwill--- debit cash (balance of actual cash),
debit goodwill (to balance), credit *persons name*, capital (agreed upon amount), credit
*persons name*, capital (agreed upon amount)
If an owner chooses to contribute additional capital during the life of the business, the
contribution is recorded as an increment in the partners capital account based on fair
value
Journal entry to record withdrawal of cash by partners: debit *persons name*, drawing (amount),
debit *persons name*, drawing (amount), credit cash (total)
At the end of each fiscal period, partnership revenues and expenses are closed out,
accompanied by an allocation of the resulting net income or loss to the partners capital
account (because separate capital balances are maintained for each partner, a method
should be laid out in the articles of partnership for how to do this)
If no arrangement has been maid *to above situation* the default is to split evenly
Profit allocation can be further complicated because some companies base it off of
behavior or accomplishment
From an accounting perspective, the assignment of income and the setting of withdrawal
limits are two separate decisions
Journal entry to close out drawing accounts recording payments made to partners: debit *persons
name*, capital (amount of money taken out), credit *persons name*, drawing (amount of money)
Journal entry to allocate net income based on provisions of partner agreement: debit income
summary (total), credit *persons name*, capital (income summary total * % of income agreed
upon)
Statement of retained earnings is usually replaced by a statement of partners capital for
partnerships
There are several other alternative allocation techniques *see textbook for example* but
ultimately, its up to the business to decide how they want to split it up fairly
If a partnership wants to add or take away a partner from the business, the previous
partnership must be dissolved first and a new one formed (legally speaking, day to day
operations can stay mostly the same usually)
An individual can gain admittance to a partnership by::: purchasing an ownership interest
from a current partner OR contributing assets directly to the business
The decision to choose between the bonus and goodwill methods depends on whether the
dissolved partnership and the new one should be viewed as two separate reporting entities
If the new partnership is just an extension of the old- no basis exists for restatement
Concerns over partnership goodwill::: recognition isn’t based on historical cost, and no
objective verification of the capitalized amount can be made.
In making a transfer of ownership, a partner can only convey 3 rights::: the right of co-
ownership in the business property, the right to share in profits and losses as specified in
the articles of partnership, and the right to participate in managing the business
Unless restricted by the articles of partnership, every partner can sell or assign the first
TWO of these rights at any time
The right to participate in managing can only be conveyed with the consent of all partners
The right to participate in managing is considered essential to the future earning power of
the business and the maintenance of business assets
Oftentimes, the relationship of the capital accounts to one another doesn’t correspond
with the partners’ profit and loss ratio
Capital balances are historical cost figures resulting from contributions and withdrawals
made throughout the life of the business as well as from the allocation of partnership
income
bonus method- Journal entry to reclassify capital to reflect a NEW partners acquisition (money is
paid direct to the partners)--- debit partnerA, capital (% of capital balance), debit partnerB,
capital (% of capital balance), debit partnerC, capital (% of capital balance), credit NEWpartner,
capital (agreed upon % of total)
goodwill method- journal entry to recognize goodwill and revaluation of assets and liabiltiies
based on value of business according to NEW partners purchase price--- debit goodwill (book
value of company- book value of company according to purchase from new person), credit
partnersABC (profit and loss corresponding %).
The bonus method (for a new partner made by contributing money to the business)
maintains the same recorded value for all partnership assets and liabilities despite the new
partners admittance… capital balance for new partner is set at predetermined level based
on the total net assets of the partnership after the payment is recorded
Bonus method- Journal entry to record NEW partners entrance into partnership: debit cash
(amount paid by new partner), credit NEWpartner, capital (% of total capital predetermined),
credit partnersAB, capital (cash – new partners % of total [total capital includes cash just paid] *
% of bonus based on profit and loss ratio)
Goodwill method- journal entry to recognize goodwill based on NEWpartner purchase price::
debit goodwill (value of company based on purchase price – capital reported), debit cash
(purchase price),credit partnersAB, capital (profit loss ratio % * goodwill), credit NEWpartner,
capital (purchase price)
If a partner leaves the business- they can elect to sell the interest to an outside party (with
approval) or to one or more of the remaining partners
Payment to the withdrawn partner is usually NOT based on the capital balance- rather its
usually solved by negotiation or appraisal (articles of partnership should specify)
The withdrawal of a partner can be accounted for under bonus/goodwill/hybrid method
Bonus method- journal entry to record LEAVINGpartner and their excess distribution- debit
LEAVINGpartner, capital (account balance), debit partnersAB, capital (% of distribution), credit
cash (given to leaving partner)
Goodwill method- ***SEE PAGE 689 IN TEXTBOOK***
The implied value of a partnership as a whole cannot be determined directly from the
amount distributed to a withdrawing partner
