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Partnerships: Formation, Operation, and Changes in Membership

Chapter 15. Partnerships: Formation, Operation, and Changes in Membership. Learning Objective 1. Understand and explain the nature and regulation of partnerships. A. B. ABC Company. What is a Partnership?. An association of two or more persons who are co-owners of a business, and

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Partnerships: Formation, Operation, and Changes in Membership

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  1. Chapter 15

    Partnerships: Formation, Operation, and Changes in Membership

  2. Learning Objective 1 Understand and explain the nature and regulation of partnerships.
  3. A B ABC Company What is a Partnership? An association of two or more persons who are co-owners of a business, and share profits and losses in an agreed-upon manner.
  4. What is a “Person”? An individual A corporation Another partnership Z Corp T&D Partnership
  5. Partnerships: Pros & Cons Advantages Ease of formation Lack of formality Single taxation (see following slide) Disadvantages Unlimited liability (for general partnerships) Difficulty in disposing of partnership interests Mutual agency
  6. Single Taxation of Partnership Earnings Partnerships only report their earnings—they are not taxed at the business entity level (as are corporations). Partnerships file IRS Form 1065, which shows the allocation of profits among partners. Partners report their share of profits on their individual IRS Form 1040 return. Partnership Form of Organization: Income Tax Reporting Uncle Sam A B AB Partnership
  7. Regulation Each state regulates the partnerships that are formed in it. Most states begin with a model act and then modifies it to fit that state’s business culture and history. Most have now adopted the Uniform Partnership Act of 1997 (UPA 1997) as their model act.
  8. The UPA 1997 covers: Relations of partners to one another. Relations of partners to persons dealing with the partnership. Dissolution and winding up of the partnership. Regulation: The Uniform Partnership Act (UPA)
  9. What is a partnership agreement? A written expression of what the partners have agreed to. Examples of areas addressed: Manner of sharing profits. Limitations on withdrawals. Rights of partners. Settling with withdrawing partners. Expulsion of partners. Conflicts of interest. The Partnership Agreement
  10. Practice Quiz Question #1 Which of the following is not one of the advantages of general partnerships? Ease of formation Unlimited liability Lack of formality Single taxation
  11. Practice Quiz Question #1 Solution Which of the following is not one of the advantages of general partnerships? Ease of formation Unlimited liability Lack of formality Single taxation
  12. Learning Objective 2 Understand and explain the differences among different types of partnerships.
  13. Types of Partnerships General Partnerships All partners have unlimited liability. Creditors can go after the personal assets of any or all of the partners.
  14. Types of Partnerships Limited Partnerships Limited partners have limited liability to partnership creditors if the partnership is unable to pay its debts. Limited partners’ risk is limited to their invested capital. Thus, personal assets are not at risk. At least one of the partners must be a general partner.
  15. Types of Partnerships Limited Liability Partnerships (LLPs) A partner’s personal assets are at risk only for his or her ownnegligence and wrongdoing, the negligence and wrongdoing of those under his or her control, but not debts. Since 1993, many accounting firms have changed from general partnerships to LLPs.
  16. Types of Partnerships Limited Liability Limited Partnerships (LLLPs) Like a limited partnership, must have at least one general partner. General partners manage the partnership. Big difference relates to the liability of general partners: No personal liability for partnership obligations (like a limited partner) Not liable for wrongdoing of other partners—just personal decisions and decisions of those supervised
  17. Practice Quiz Question #2 Which of the following statements is true? The partners in a general partnership have limited liability. At least two of the partners in a limited partnership must be general partners. Partners in an LLP are not responsible for their own actions. Limited liability limited partnerships must have at least one general partner.
  18. Practice Quiz Question #2 Solution Which of the following statements is true? The partners in a general partnership have limited liability. At least two of the partners in a limited partnership must be general partners. Partners in an LLP are not responsible for their own actions. Limited liability limited partnerships must have at least one general partner.
  19. Learning Objective 3 Make calculations and journal entries for the formation of partnerships.
  20. Partners’ Accounts Each partner can have a capital account. a drawing account (a contra capital account—closed out at year-end). a loan account (loans usually earn interest—a partnership expense). Partnerships do NOT use aretained earnings account. DR CR
  21. Keep it FAIR! Current Fair Market Values should be used to record noncash assets contributed to a partnership. liabilities assumed by a partnership. Recording Capital Contributions ABC Partnership
  22. Partnership Formation Example Brian and Spencer wish to form the B&S partnership. Brian contributes land with a book value of $65,000 and a current value of $150,000 and a building with a book value of $142,000 and a current value of $175,000. Spencer will contribute cash. If the partners plan to share profits and losses equally after the formation of the partnership and assuming they have agreed to equal capital contributions, how much cash will Spencer have to contribute to form the partnership? $150,000 + $175,000 = $325,000
  23. Comprehensive Partnership Creation Problem The partnerships of Brad & Mike (B&M) and Austin and Justin (A&J) began business on 1/1/X1; each partnership owns one retail appliance store. The two partnerships agree to combine as of 7/1/X8 to form a new partnership, BAM-J Discount Stores. REQUIRED Given the information on the next two slides, Prepare the journal entries to record the initial capital contribution after considering the effect of this information. Use separate entries for each of the combining partnerships. Prepare a schedule computing the cash contributed or withdrawn by each partner to bring the initial capital balances into the profit and loss sharing ratio.
  24. Comprehensive Partnership Creation Problem Profit and loss ratios. The profit and loss sharing ratios for the former partnerships were 40% to Brad and 60% to Mike, and 30% to Austin and 70% to Justin. The profit and loss sharing ratio for the new partnership is Brad, 20%; Mike, 30%; Austin, 15%; and Justin, 35%. Capital investments. The opening capital investments for the new partnership are to be in the same ratio as the profit and loss sharing ratios for the new partnership. If necessary, certain partners may have to contribute additional cash, and others may have to withdraw cash to bring the capital investments into the proper ratio. Accounts receivable. The partners agreed to set the new partnership’s allowance for bad debts at 3% of the accounts receivable contributed by B&M and 12% of the accounts receivable contributed by A&J. Inventory. The new partnership’s opening inventory is to be valued by the FIFO method. B&M used the FIFO method to value inventory (which approximates its current value), and A&J used the LIFO method. The LIFO inventory represents 85% of its FIFO value. Property and equipment. The partners agree that the building’s current value is approximately 70% of the building’s historical cost, as recorded on each partnership’s books. Unpaid liability. After each partnership’s books were closed on 6/30/X8, an unrecorded merchandise purchase of $1,500 by A&J was discovered. The merchandise had been sold by 6/30/X8. The 6/30/X8 postclosing trial balances of the partnerships follow.
  25. Comprehensive Partnership Creation Problem Prepare the journal entries to record the initial capital contribution after considering the effect of this information. Use separate entries for each of the combining partnerships. Prepare a schedule computing the cash contributed or withdrawn by each partner to bring the initial capital balances into the profit and los sharing ratio.
  26. Comprehensive Problem Solution PART 1 Summary of changes to carrying values: Allocate to:
  27. Comprehensive Problem Solution Brad & Mike Journal Entry: Cash 25,000 Accounts Receivable 100,000 Allowance for doubtful accounts 3,000 Inventory 175,000 Building & Equipment 73,500 Accounts Payable 40,000 Notes Payable 100,000 Brad, Capital 91,600 Mike, Capital 138,900
  28. Comprehensive Problem Solution Austin & Justin Journal Entry: Cash 22,000 Accounts Receivable 150,000 Allowance for doubtful accounts 18,000 Inventory 140,000 Building & Equipment 112,000 Accounts Payable 61,500 Notes Payable 120,000 Austin, Capital 71,150 Justin, Capital 153,350
  29. Comprehensive Problem Solution PART 2
  30. Learning Objective 4 Make calculations and journal entries for the operation of partnerships.
  31. 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 Capital Investment Contributions % Loss % Profit Drawings
  32. 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
  33. Practice Quiz Question #3 Which of the following would result in a reduction to a partner’s capital account? a. The initial investment. b. The allocation of a profit. c. Additional capital contributions. d. A withdrawal. e. A loan to a partner.
  34. Practice Quiz Question #3 Solution Which of the following would result in a reduction to a partner’s capital account? a. The initial investment. b. The allocation of a profit. c. Additional capital contributions. d. A withdrawal. e. A loan to a partner.
  35. Learning Objective 5 Make calculations and journal entries for the allocation of partnership profit or loss.
  36. Partners can share profits and losses in any way they choose. Possible ways include ratios. salary allowances and ratios. imputed interest on capital, salary allowances, and ratios. capital balances only. performance methods. Sharing Profits and Losses
  37. Income Allocation Example Assume that in its first year of operation, B&S partnership earns $162,000 of income. What journal entry would B&S make to allocate the profits between the two partners? Profit & Loss Summary 162,000 Capital, Brian 81,000 Capital, Spencer 81,000
  38. Group Exercise 1: Allocating Profit and Loss, No Restrictions The partnership of Alex and James has the following provisions: Alex and James receive salary allowances of $37,000 and $18,000, respectively. Interest is imputed at 10% on the average capital investment. Any remaining profit or loss is shared between Alex and James in a 3:2 ratio, respectively. Average Capital investments: Alex, $ 50,000; James, 130,000 REQUIRED 1. Prepare a schedule showing how the profit would be divided, assuming the partnership profit or loss is: a. $ 102,000 b. $ 57,000 c. $(34,000) 2. What journal entry should be made to allocate the profit or loss for each of the three cases listed above?
  39. Group Exercise 1: Solution for part a 37,000 18,000 (55,000) 5,000 13,000 (18,000) 29,000 (29,000) 17,400 11,600 42,600 59,400 0 Income Summary 102,000 Capital, Alex 59,400 Capital, James 42,600
  40. Group Exercise 1: Allocating Profit and Loss, No Restrictions The partnership of Alex and James has the following provisions: Alex and James receive salary allowances of $37,000 and $18,000, respectively. Interest is imputed at 10% on the average capital investment. Any remaining profit or loss is shared between Alex and James in a 3:2 ratio, respectively. Average Capital investments: Alex, $ 50,000; James, 130,000 REQUIRED 1. Prepare a schedule showing how the profit would be divided, assuming the partnership profit or loss is: a. $ 102,000 b. $ 57,000 c. $(34,000) 2. What journal entry should be made to allocate the profit or loss for each of the three cases listed above?
  41. Group Exercise 1: Solution for part b Income Summary 57,000 Capital, Alex 32,400 Capital, James 24,600
  42. Group Exercise 1: Allocating Profit and Loss, No Restrictions The partnership of Alex and James has the following provisions: Alex and James receive salary allowances of $37,000 and $18,000, respectively. Interest is imputed at 10% on the average capital investment. Any remaining profit or loss is shared between Alex and James in a 3:2 ratio, respectively. Average Capital investments: Alex, $ 50,000; James, 130,000 REQUIRED 1. Prepare a schedule showing how the profit would be divided, assuming the partnership profit or loss is: a. $ 102,000 b. $ 57,000 c. $(34,000) 2. What journal entry should be made to allocate the profit or loss for each of the three cases listed above?
  43. Group Exercise 1: Solution for part c Capital, Alex 22,200 Capital, James 11,800 Income Summary 34,000
  44. Methods to Share Profits and Losses: “To the Extent Possible” Limitations When a “limit” provision exists: The next lower level method of sharing can be reached if and only if there is still unallocated profit remaining after dealing with the current level.
  45. Group Exercise 2: Allocating Profit and Loss—“Limit” Assume the same information provided in Group Exercise 1, except that the partnership agreement stipulates the following order of priority: Salary allowances (only to the extent available) Imputed interest on average capital investments (only to the extent available). Any remaining profit in a 3:2 ratio. (No mention is made regarding losses.) REQUIRED: The requirements are the same as for Group Exercise 1 (i.e., calculate the allocations and prepare journal entries). a. $ 102,000 b. $ 57,000 c. $ (34,000)
  46. Group Exercise 2: Solution for part a Income Summary 102,000 Capital, Alex 59,400 Capital, James 42,600
  47. Group Exercise 2: Allocating Profit and Loss—“Limit” Assume the same information provided in Group Exercise 1, except that the partnership agreement stipulates the following order of priority: Salary allowances (only to the extent available) Imputed interest on average capital investments (only to the extent available). Any remaining profit in a 3:2 ratio. (No mention is made regarding losses.) REQUIRED: The requirements are the same as for Group Exercise 1 (i.e., calculate the allocations and prepare journal entries). a. $ 102,000 b. $ 57,000 c. $ (34,000)
  48. Group Exercise 2: Solution for part b * $2,000 x (5,000 ÷ $18,000) = 556 $2,000 x ($13,000 ÷ $18,000) = 1,444 Income Summary 57,000 Capital, Alex 37,556 Capital, James 19,444
  49. Group Exercise 2: Solution for part c In this case, the partnership agreement is vague. An argument can be made for allocating the loss equally pursuant the UPA 1997 because the partnership agreement is silent with respect to losses. Alternatively, we could presume that losses were intended to be shared in the residual profit-sharing ratio. In these cases, the accountant should seek clarification from each partner.
  50. Practice Quiz Question #4 Matt and Chad created a partnership (M&C) on 12/31/X8 (sharing profits 50/50). Matt contributed equipment from his sole proprietorship having a carrying valueof $4,000 and a fair valueof $8,000. In 20X9, M&C had profits of $96,000 and borrowed $20,000 from a bank. In 2009, Matt withdrew $35,000 cash. Matt’s Y/E capital balance is a. $11,000. b. $17,000. c. $21,000. d. $56,000.
  51. Practice Quiz Question #4 Solution Matt and Chad created a partnership (M&C) on 12/31/X8 (sharing profits 50/50). Matt contributed equipment from his sole proprietorship having a carrying valueof $4,000 and a fair valueof $8,000. In 20X9, M&C had profits of $96,000 and borrowed $20,000 from a bank. In 2009, Matt withdrew $35,000 cash. Matt’s Y/E capital balance is a. $11,000. b. $17,000. c. $21,000 ($8,000 + $96,000/2 - $35,000) d. $56,000.
  52. Learning Objective 6 Make calculations and journal entries to account for changes in partnership ownership.
  53. Interest $ Partner’s Admission: Purchase of An Existing Interest The purchase of an interest from one or more of a partnership’s existing partners is a: personal transaction between the incoming partner and the selling partner(s). The only entry required on the partnership’s books is to transfer an amount: from the selling partner’s Capital account. to the new partner’s Capital account. C A B AB Partnership
  54. A B C C ABC Partnership Assets A B AB Partnership Partner’s Admission: Adding a New Partner Key Objective Achieve equity among the partners + =
  55. A B C C ABC Partnership Assets A B AB Partnership How to Achieve Equity? Example + =  How much would C have to contribute?  What factors would you have to consider?
  56. How to Achieve Equity? Example Q: What if the land has a current value of $200,000? Assume C contributes $150,000 (FMV of value owned by A and B) for a 1/3 interest in assets, profits, and losses. Q: What if the land is sold the next day for $200,000?
  57. ≠ Minimizing Inequities The Three Methods The revaluing of assets / goodwill method. The bonus method. The special profit-and-loss sharing provision method. Some methods can still result in inequities if events do not materialize as assumed.
  58. ≠ Minimizing Inequities The Three Methods The revaluing of assets / goodwill method. The bonus method. The special profit-and-loss sharing provision method. Some methods can still result in inequities if events do not materialize as assumed.
  59. (1) Revaluing of Assets Method Q:What if the land has a current value of $200,000? A:Simply “revalue” the land before admitting C! Q: How do you record C’s contribution? Q:What if the land is sold two years later for $230,000? A:Each gets $10,000 of gain. Land 100,000 Capital, A 50,000 Capital, B 50,000 Cash 150,000 Capital, C 150,000
  60. (2) Bonus Method The partners agree to share equally in all future gains or losses on the disposal of the land. However, C’s capital account is decreased up front by the amount of the first $100,000 of gain that he/she will receive ($33,333). This decrease is added to A’s and B’s capital accounts up front. Q: Given that the land has a current value of $200,000? Cash 150,000 Capital, A 16,667 Capital, B 16,667 Capital, C 116,667 Q:What if the land is sold two years later for $230,000? A:Each gets $43,333 of gain.
  61. (3) Special Profit and Loss Sharing Provision Q: Given that the land has a current value of $200,000? Q:What if the land is sold two years later for $230,000? A: A and B share equally in the first $100,000 of gain and all partners share equally in the additional $30,000 of gain. A and B each get $60,000 and C gets $10,000 of the gain. Specify in the new partnership agreement that the land’s current value is $200,000 and that partners A and B share equally (or in some other specified manner) in the first $100,000 of gain when the land is disposed of. Cash 150,000 Capital, C 150,000
  62. Summary of the Three Methods: Before Land is Sold for $230,000 Revaluing of assets Cash $250,000 Capital, A $150,000 Capital, B 150,000 Land 200,000 Capital, C 150,000 Total Assets $450,000 Total Equity $450,000 Gain of $30,000 allocated equally to A, B, & C ($10,000 each) (2) Bonus Cash $250,000 Capital, A $116,667 Capital, B 116,667 Land 100,000 Capital, C 116,667 Total Assets $350,000 Total Equity $350,000 Gain of $130,000 allocated equally to A, B, & C ($43,333 each) Special P&L Sharing Cash $250,000 Capital, A $100,000 Capital, B 100,000 Land 100,000 Capital, C 150,000 Total Assets $350,000 Total Equity $350,000 Gain of $130,000: allocate $60,000 to A & B and $10,000 to C
  63. Summary of the Three Methods: After Land is Sold for $230,000 Revaluing of assets Cash $480,000 Capital, A $160,000 Capital, B 160,000 Capital, C 160,000 Total Assets $480,000 Total Equity $480,000 (2) Bonus Cash $480,000 Capital, A $160,000 Capital, B 160,000 Capital, C 160,000 Total Assets $480,000 Total Equity $480,000 Special P&L Sharing Cash $480,000 Capital, A $160,000 Capital, B 160,000 Capital, C 160,000 Total Assets $480,000 Total Equity $480,000 We get the same result under each method!
  64. ≠ Minimizing Inequities Only the special profit-and loss sharing provision method will prevent an inequity to one or more of the partners in the event that the agreed-upon values of the assets are erroneous. the agreed-upon value of goodwill does not materialize.
  65. Key Differences Between Revaluation / Goodwill and Bonus Methods Revaluation/Goodwill Method Revalue the balance sheet by recording goodwill or revaluing existing assets. Thus, we now have a bigger “pie” to divide up among the partners. Excess Value Book Value of Net Assets Land 100,000 Capital, A 50,000 Capital, B 50,000
  66. Key Differences Between Revaluation / Goodwill and Bonus Methods Revaluation/Goodwill Method Revalue the balance sheet by recording goodwill or revaluing existing assets. Thus, we now have a bigger “pie” to divide up among the partners. The new partner’s capital account will be equal to his/her ownership percentage of the “Big Pie.” Land = $100,000 x 1/3 = $150,000 Small Pie = 200,000 + 150,000 = 350,000 Cash 150,000 Capital, C 150,000
  67. Key Differences Between Revaluation / Goodwill and Bonus Methods Bonus Method Do not revalue the balance sheet. Only leaves the book value of net assets on the balance sheet. Book Value of Net Assets
  68. Key Differences Between Revaluation / Goodwill and Bonus Methods Bonus Method Do not revalue the balance sheet. Only leaves the book value of net assets on the balance sheet. The new partner’s capital account will be equal to his/her ownership percentage of the “Small Pie.” Small Pie = 200,000 + 150,000 = 350,000 x 1/3 = $116,667 Cash 150,000 Capital, A 16,667 Capital, B 16,667 Capital, C 116,667
  69. The Revaluing of Assets / Goodwill Method Advantages Credit to incoming partner always at least equal to cash contribution Can be important “psychologically” Disadvantages Departs from GAAP Complicates income tax preparation
  70. The Bonus Method Major Advantages Does not result in a departure from GAAP Minimizes bookkeeping and tax return effort Major Disadvantages A portion of one or more partner’s capital balance is transferred to one or more other partners. The hope is that the transferred amount will later be recouped via future profits. Incoming partner’s capital account may be less than his/her cash contribution!
  71. Determining the Value of Goodwill Steps to follow: Estimate the implied value of the partnership based on the new partner’s contribution. New capital contribution ÷ new partner ownership % Estimate the implied value of the partnership based on the old partners’ total equity. Total old partner capital balance ÷ total old ownership % Calculate the amount of existing net assets. The sum of old partner capital and new partner contributed capital. Calculate implied goodwill Implied value (greater of 1 or 2) – existing net assets (3) Determine whether the new or old partners possess goodwill. The smaller of 1 or 2 The one who paid less for their relative share.
  72. Practice Quiz Question #5a Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). The old partners capital accounts are not to decrease (i.e., use the Revaluation / Goodwill method). Betsy’s capital account is credited: $ 9,000 $54,000 $58,500 $60,000 $76,500
  73. Solution, Summary New implied value: $ 54,000 ÷ 25% = $ 216,000 Old implied value: $ 180,000 ÷ 75% = $ 240,000 BV of net assets: $ 180,000 + $54,000 = $ 234,000 Implied Goodwill = $ 240,000  $234,000 = $ 6,000 Goodwill belongs to new partner (because $216,000 is less than $240,000). [Implies that she paid less for her relative share of the business.] Since we’re revaluing, use the BIG pie: GW = 6,000 234,000 The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only) x 25% = $60,000
  74. Practice Quiz Question #5a Solution Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). The old partners capital accounts are not to decrease (i.e., use the Revaluation / Goodwill method). Betsy’s capital account is credited: $ 9,000 $54,000 $58,500 $60,000 ($240,000 x 25%) $76,500 Betsy’s share of the “big pie.” Cash 54,000 Goodwill 6,000 Capital, Betsy 60,000
  75. Practice Quiz Question #5b Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). Use the Bonus Method.Betsy’s capital account is credited $ 9,000. $54,000. $58,500. $60,000. $76,500.
  76. Solution, Summary New implied value: $ 54,000 ÷ 25% = $ 216,000 Old implied value: $ 180,000 ÷ 75% = $ 240,000 BV of net assets: $ 180,000 + $54,000 = $ 234,000 Implied Goodwill = $ 240,000  $234,000 = $ 6,000 Goodwill belongs to new partner (because $216,000 is less than $240,000). [Implies that she paid less for her relative share of the business.] Since we’re not revaluing, use the Small pie: The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only) Small Pie = 180,000 + 54,000 = 234,000 x 25% = $58,500
  77. Practice Quiz Question #5b Solution Betsy contributes $54,000 cash for a 25% interest in the new net assets of the partnership (that has existing equity of $180,000). Use the Bonus Method. Betsy’s capital account is credited: $ 9,000. $54,000. $58,500. $60,000. $76,500. Cash 54,000 Capital, Old Part. 4,500 Capital, Betsy 58,500 Betsy’s share of the “Small Pie.”
  78. Group Exercise: Goodwill Method Scott and Stephanie are partners with capital balances of $100,000 and $65,000, and they share profits and losses in the ratio of 3:2, respectively. Zoe invests $60,000 cash for a 25% interest in the capital and profits of the new partnership. The partners agree that the implied partnership goodwill is to be recorded simultaneously with the admission of Zoe. REQUIRED Calculate the firm’s total implied goodwill. Prepare the entry or entries to record the admission of Zoe.
  79. Solution, Summary New implied value: $ 60,000 ÷ 25% = $ 240,000 Old implied value: $ 165,000 ÷ 75% = $ 220,000 BV of net assets: $ 165,000 + $60,000 = $ 225,000 Implied Goodwill = $ 240,000  $225,000 = $ 15,000 Goodwill belongs to old partners (because $220,000 is less than $240,000). [Implies that they “gave” less for their relative share of the business.] The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only)
  80. Group Exercise: Goodwill Method Solution Entry to record Goodwill Goodwill 15,000 Capital, Scott 9,000 Capital, Stephanie 6,000 GW = 15,000 165,000 + 60,000 = 225,000 Entry to record Zoe’s cash contribution Cash 60,000 Capital, Zoe 60,000 Note that this is 25% of the “Big Pie” because we revalue the balance sheet! x 25% = $60,000
  81. Group Exercise: Bonus Method Jim and June are partners who share profits and losses in the ratio of 2:1, respectively. On 12/31/X8 their capital accounts are as follows: Jim $ 40,000 June 30,000 Total $ 70,000 On that date, they agreed to admit Mel as a partner with a 30% interest in the capital and profits and losses for an investment of $15,000. The new partnership will begin with total capital of $85,000. REQUIRED Prepare the entry or entries to record the admission of Mel.
  82. Solution, Summary New implied value: $ 15,000 ÷ 30% = $ 50,000 Old implied value: $ 70,000 ÷ 70% = $ 100,000 BV of net assets: $ 70,000 + $15,000 = $ 85,000 Implied Goodwill = $ 100,000  $85,000 = $ 15,000 Goodwill belongs to new partner (because $50,000 is less than $100,000). [Implies that he “gave” less for his relative share of the business.] The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only) Note that we use the small pie here with bonus method.
  83. Group Exercise: Goodwill Method Solution Entry to record admission of Mel Cash 15,000 Capital, Jim 7,000 Capital, June 3,500 Capital, Mel 25,500 Note that this is 30% of the “Small Pie” because we don’t revalue the balance sheet! Small Pie = 70,000 + 15,000 = 85,000 Note:The bonus to the new partner is shared between the old partners in their old profit and loss sharing ratio of 2:1. x 30% = $25,500
  84. Comprehensive Group Problem Jenn and Amanda are in partnership—they share profits and losses in the ratio of 7:1, respectively, and they have capital balances of $30,000 each. The partnership’s land has a fair value of $30,000 in excess of book value. Tommy is admitted into the partnership for a cash contribution of $25,000. The new profit and loss sharing formula is Jenn, 70%, Amanda, 10%, and Tommy, 20%. The value of the partnership’s existing goodwill is agreed to be $10,000. REQUIRED Prepare the required entries, assuming the land is to be revalued and the goodwill is to be recorded on the partnership’s books. Prepare the required entries, assuming that the bonus method is to be used with respect to the undervalued existing assets and the goodwill. Note that this goodwill number is given because it is a bit harder to calculate when there is also unrecorded appreciation in existing assets. However, the next slide shows the calculation.
  85. Solution, Summary New implied value: $ 25,000 ÷ 20% = $ 125,000 Old implied value:$ 60,000 ÷ 80% = $ 75,000 BV of net assets: $ 60,000 + $25,000 = $85,000 Total Excess Value = $ 125,000  $85,000 = $ 40,000 Goodwill = Total Excess Value – Excess Land Value Goodwill = $40,000 - $30,000 = $10,000 5. Goodwill belongs to the old partners (because $75,000 is less than $125,000). [Implies that they “gave” less for their relative share of the business.] GW = 10,000 60,000 + 25,000 = 85,000 The BIG PIE (BV of NA + Goodwill) The SMALL PIE (BV Only) Land = 30,000
  86. Comprehensive Group Problem Solution PART 1 (Revaluation / Goodwill Method): To revalue existing assets to their current values. To record goodwill. To record cash contribution by Tommy. Land 30,000 Capital, Jenn 26,250 Capital, Amanda 3,750 GW = 10,000 60,000 + 25,000 = 85,000 Goodwill 10,000 Capital, Jenn 8,750 Capital, Amanda 1,250 Cash 25,000 Capital, Tommy 25,000 Note that this is 20% of the “Big Pie.” x 20% = $25,000 Land = 30,000
  87. Comprehensive Group Problem Solution PART 2 (Bonus Method): If the partnership were sold one day after Tommy was admitted and the selling price was $40,000 more than the book value of the net assets, Tommy would share in the $40,000 gain to the extent of $8,000 (20% × $40,000), the amount of his capital contribution that is given as a bonus to Jenn and Amanda. Cash 25,000 Capital, Jenn 7,000 Capital, Amanda 1,000 Capital, Tommy 17,000 Note that this is 20% of the “Small Pie” without revaluing the land ($60,000 + $25,000). Note:The bonus to be given the old partners is Tommy’s profit and loss sharing percentage of 20% multiplied by the sum of the undervalued existingassets ($30,000) and the goodwill ($10,000). Small Pie = 60,000 + 25,000 = 85,000 x 20% = $17,000
  88. A major risk of joining an existing partnership is the general practice of requiring the new partner to become jointly responsible for all pre-existing partnership liabilities. all pre-existing contingent liabilities. Legal Aspects: Joining a Partnership
  89. Legal Aspects: Withdrawing from a Partnership A partner that withdraws from a partnership is still responsible for the following items that exist at the time of the withdrawal: all partnership obligations, and all contingent liabilities, Only creditors can expressly release a partner from this responsibility.
  90. Legal Aspects: Withdrawing from a Partnership Disassociation A broad term that refers to when a partner is no longer associated with a partnership. Dissolution A narrow term that refers to when a (1) partnership is dissolved, and (2) its affairs must be wound up. Thus, the partnership’s existence is terminated.
  91. Practice Quiz Question #6 Upon withdrawal from a partnership, Cliff received $14,000 cash in excess of his capital balance. Cliff’s share of profits and losses was20%. Partnership land was undervalued by $50,000. The total partnership goodwill is $ 4,000. $20,000. $24,000 $70,000.
  92. Solution
  93. Practice Quiz Question #6 Solution Upon withdrawal from a partnership, Cliff received $14,000 cash in excess of his capital balance. Cliff’s share of profits and losses was20%. Partnership land was undervalued by $50,000. The total partnership goodwill is $ 4,000. $20,000. (5 x [$14,000 - {20% x $50,000}]) $24,000 $70,000.
  94. Group Exercise: Retirement The 6/30/X8 balance sheet of the partnership of Sandy, Rees, and Raymond as follows. The partners share profits and losses in the ratio of 2:2:6, respectively. Assets at cost $145,000 Sandy, loan 9,000 Other liabilities 17,000 Capital, Sandy 20,000 Capital, Rees 37,000 Capital, Raymond 62,000 Sandy retires from the partnership. By mutual agreement, the assets are to be adjusted to their fair value of $150,000 at 6/30/X8. Rees and Raymond agree that the partnership will pay Sandy $45,000 cash for her partnership interest, exclusive of her loan, which is to be paid in full. No goodwill is to be recorded. REQUIRED Prepare the entry to record the revaluation of assets to fair value. Prepare the entry to record Sandy’s retirement. What is the implicittotal goodwill for the partnership?
  95. Group Exercise Solution PART 1 Assets 5,000 Capital, Sandy 1,000 Capital, Rees 1,000 Capital, Raymond 3,000 To revalue assets to their current value. PART 2 Capital, Sandy 21,000 Capital, Rees 6,000 Capital, Raymond 18,000 Cash 45,000 To record the withdrawal of Sandy. PART 3 Sandy received a bonus of $24,000, which was equal to her share of the goodwill. Because Sandy’s profit and loss sharing ratio was 20%, the total goodwill must have been $120,000 ($24,000 ÷ 20%).
  96. Conclusion The End
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