BAKER LEMBKE KING advanced financial accounting 8e chapter 015

Nature of Partnership Entity– 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

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

– 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

agreement, and 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

• 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

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

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

• Multiple bases of profit allocation

– 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

– 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

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

– 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

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