Advanced financial accounting by baker chapter 15

Nature of Partnership Entity– Partnership agreement: The UPA 1997 is used by the courts when there is no partnership agreement– Partnership as a separate entity: The entity concept mean

Partnerships: Formation, Operation, and

Changes

in Membership

15

Overview

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

Nature of Partnership Entity

– 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

Nature of Partnership Entity

– 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 ”

Nature of Partnership Entity

• Definition of a partnership

may be individuals, corporations or other partnerships

apparent authority, unless restricted by the partnership agreement, to act as an agent of the partnership for transactions in the ordinary course of business

make a profit; therefore, not-for-profit entities, such as fraternal groups, may not organize as partnerships

partners are strongly advised to have a formal written agreement to avoid potential problems later

Nature of Partnership Entity

– 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

Nature of Partnership Entity

– 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

Nature of Partnership Entity

– 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

Nature of Partnership Entity

– 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

Nature of Partnership Entity

– 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

Nature of Partnership Entity

– 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

Nature of Partnership Entity

– 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

Nature of Partnership Entity

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

Accounting for 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

Accounting for the Formation of a

Partnership

assets should be valued at their fair values, which may require appraisals or other

valuation techniques

should be valued at the present value of the remaining cash flows

Accounting for the Formation of a

Partnership

percentage of equity that each will have in

the net assets of the partnership

by the proportionate share of each partner’s capital contribution

• 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

Accounting for Operations of a

Partnership

– 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

Allocating Profit or Loss to Partners

the end of each period in accordance with

the partnership agreement

share profits and losses equally (UPA 1997)

– Preselected ratio

– Interest on capital balances

– Salaries to partners

– Bonuses to partners

Allocating Profit or Loss to Partners

with a closing entry at the end of each

period

an income summary account or directly into the partners’ capital accounts

Allocating Profit or Loss to Partners

– A combination of several allocation procedures:

– Agreement should have a provision to specify the allocation

process in a deficiency situation

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.

Partnership Financial Statements

statements, a statement of partners’ capital

is prepared to present the changes in the

partners’ capital accounts for the period

Changes in Membership

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

Changes in Membership

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

Changes in Membership –

General concepts

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

Changes in Membership –

General concepts

• Recognizing decreases in net asset revaluations

impairments of currently held goodwill

recognizing impairment losses on long-lived assets

appropriate accounting standards are in accordance with GAAP

increases in the value of nonfinancial assets or recognition of new goodwill, solely due to a change in

Changes in Membership –

General concepts

– 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

Changes in Membership –

General concepts

partners’ interests and the use of non-GAAP accounting

– Partners may use non-GAAP accounting methods that meet

their information needs

– 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

New Partner Invests in Partnership

partner’s proportion of the partnership’s

book value:

New Partner Invests in Partnership

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

New Partner Invests in Partnership

New Partner Invests in Partnership

cost

– It is important to note the total resulting capital of the

partnership and the percentage of ownership interest retained

by the prior partners

Dissociation of a Partner

the dissociated partner’s interest in the

partnership for a buyout price

– 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

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

Dissociation of a Partner

– If the partnership is unable to pay the amount at the time of

retirement, it must recognize a liability for the remaining portion

Dissociation of a Partner

• Buyout price greater than partner’s capital credit

above the dissociating partner’s capital credit as a capital adjustment bonus to the partner from the capital accounts of the remaining partners

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

Dissociation of a Partner

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