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1. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Chapter 15
Partnerships: Formation,
Operation, and Changes in
Membership

2. 15-2
Understand and explain the
nature and regulation of
partnerships.
Learning Objective 1

3. 15-3
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. ABC
Company
A B

4. 15-4
What is a “Person”?
 An individual
 A corporation
 Another partnership
Z Corp
T&D
Partnership

5. 15-5
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. 15-6
Partnership Form of Organization: Income Tax
Reporting
 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.
AB
Partnership
A B
Uncle Sam

7. 15-7
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. 15-8
Regulation: The Uniform Partnership Act (UPA)
 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.

9. 15-9
The Partnership Agreement
 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.

10. 15-10
Practice Quiz Question #1
Which of the following is not one of
the advantages of general
partnerships?
a. Ease of formation
b. Unlimited liability
c. Lack of formality
d. Single taxation

11. 15-11
Learning Objective 2
Understand and explain the
differences among different
types of partnerships.

12. 15-12
Types of Partnerships
 General Partnerships
 All partners have unlimited liability.
 Creditors can go after the personal assets of
any or all of the partners.

13. 15-13
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.

14. 15-14
Types of Partnerships
 Limited Liability Partnerships (LLPs)
 A partner’s personal assets are at risk only for
 his or her own negligence 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.

15. 15-15
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

16. 15-16
Practice Quiz Question #2
Which of the following statements is true?
a. The partners in a general partnership
have limited liability.
b. At least two of the partners in a limited
partnership must be general partners.
c. Partners in an LLP are not responsible
for their own actions.
d. Limited liability limited partnerships
must have at least one general partner.

17. 15-17
Learning Objective 3
Make calculations and journal
entries for the formation of
partnerships.

18. 15-18
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 a
retained earnings account. DR CR

19. 15-19
Recording Capital Contributions
 Keep it FAIR!
 Current Fair Market
Values should be used to
record
 noncash assets contributed
to a partnership.
 liabilities assumed by a
partnership. ABC
Partnership

20. 15-20
$150,000 + $175,000 = $325,000
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?

21. 15-21
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,
1. 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.
2. 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.

22. 15-22
Comprehensive Partnership Creation Problem
1. 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%.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. The 6/30/X8 postclosing trial balances of the partnerships follow.

23. 15-23
Comprehensive Partnership Creation Problem
Account
Brad & Mike Trial
Balance – June 30, 20X8
Austin & Justin Trial
Balance – June 30, 20X8
Cash 25,000 22,000
Accounts Receivable 100,000 150,000
Allowance for doubtful accounts 2,000 6,000
Inventory 175,000 119,000
Building & Equipment 105,000 160,000
Accumulated Depreciation 24,000 61,000
Accounts Payable 40,000 60,000
Notes Payable 100,000 120,000
Brad, Capital 95,000
Mike, Capital 144,000
Austin, Capital 65,000
Justin, Capital 139,000
Totals 405,000 405,000 451,000 451,000
1. 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.
2. 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.

24. 15-24
Learning Objective 4
Make calculations and journal
entries for the operation of
partnerships.

25. 15-25
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
% Profit
% Loss

26. 15-26
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

27. 15-27
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.

28. 15-28
Learning Objective 5
Make calculations and journal
entries for the allocation of
partnership profit or loss.

29. 15-29
Profit & Loss Summary 162,000
Capital, Brian 81,000
Capital, Spencer 81,000
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?

30. 15-30
Sharing Profits and Losses
 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.

31. 15-31
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?
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

32. 15-32
ALLOCATED TO
Alex James Total
Total Profit
Salary
Interest on Capital
Residual Profit
Allocate Profit
Group Exercise 1: Solution for part a

33. 15-33
ALLOCATED TO
Alex James Total
Total Profit
Salary
Interest on Capital
Residual Profit
Allocate Profit
Group Exercise 1: Solution for part b

34. 15-34
ALLOCATED TO
Alex James Total
Total Profit
Salary
Interest on Capital
Residual Profit
Allocate Profit
Group Exercise 1: Solution for part c

35. 15-35
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.

36. 15-36
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:
1. Salary allowances (only to the extent available)
2. Imputed interest on average capital investments (only to
the extent available).
3. 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)

37. 15-37
ALLOCATED TO
Alex James Total
Total Profit
Salary
Interest on Capital
Residual Profit
Allocate Profit
Group Exercise 2: Solution for part a

38. 15-38
ALLOCATED TO
Alex James Total
Total Profit
Salary
Interest on Capital *
Residual Profit
Allocate Profit
Group Exercise 2: Solution for part b

39. 15-39
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 value of
$4,000 and a fair value of $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.

40. 15-40
Learning Objective 6
Make calculations and journal
entries to account for changes in
partnership ownership.

41. 15-41
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
Interest $
AB
Partnership
A B

42. 15-42
Partner’s Admission: Adding a New Partner
 Key Objective
 Achieve equity among the partners
AB
Partnership
A B
+
C
Assets
= ABC
Partnership
A B C

43. 15-43
How to Achieve Equity?
Example
AB
Partnership
A B
+
C
Assets
= ABC
Partnership
A B C
 How much would C have to contribute?
 What factors would you have to consider?
Cash $100,000 Capital, A $100,000
Land 100,000 Capital, B 100,000
Total Assets $200,000 Total Equity $200,000

44. 15-44
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?
Cash $100,000 Capital, A $100,000
Land 100,000 Capital, B 100,000
Total Assets $200,000 Total Equity $200,000

45. 15-45
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.
≠

46. 15-46
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.
≠

47. 15-47
(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.
Cash $100,000 Capital, A $150,000
Land 200,000 Capital, B 150,000
Total Assets $300,000 Total Equity $300,000
Land 100,000
Capital, A 50,000
Capital, B 50,000
Cash 150,000
Capital, C 150,000

48. 15-48
Q: Given that the land has a current value of $200,000?
(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.
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.

49. 15-49
(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.
Cash 150,000
Capital, C 150,000
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.

50. 15-50
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
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
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
(1) Revaluing
of assets
(3) Special
P&L
Sharing
(2) Bonus
Gain of $30,000 allocated equally to A, B, & C ($10,000 each)
Gain of $130,000: allocate $60,000 to A & B and $10,000 to C
Gain of $130,000 allocated equally to A, B, & C ($43,333 each)
Summary of the Three Methods: Before Land
is Sold for $230,000

51. 15-51
Cash $480,000 Capital, A $160,000
Capital, B 160,000
Capital, C 160,000
Total Assets $480,000 Total Equity $480,000
Cash $480,000 Capital, A $160,000
Capital, B 160,000
Capital, C 160,000
Total Assets $480,000 Total Equity $480,000
Cash $480,000 Capital, A $160,000
Capital, B 160,000
Capital, C 160,000
Total Assets $480,000 Total Equity $480,000
(1) Revaluing
of assets
(3) Special
P&L
Sharing
(2) Bonus
We get the same result under each method!
Summary of the Three Methods: After Land is
Sold for $230,000

52. 15-52
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.
≠

53. 15-53
Key Differences Between Revaluation /
Goodwill and Bonus Methods
Revaluation/Goodwill Method
 Revalue the balance sheet by
recording goodwill or revaluing
tangible assets.
 Thus, we now have a bigger “pie”
to divide up among the partners.
Land 100,000
Capital, A 50,000
Capital, B 50,000
Excess Value
Book Value
of Net Assets

54. 15-54
Key Differences Between Revaluation /
Goodwill and Bonus Methods
Revaluation/Goodwill Method
 Revalue the balance sheet by
recording goodwill or revaluing
tangible 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.”
Cash 150,000
Capital, C 150,000
Land = $100,000
Small Pie =
200,000 +
150,000 =
350,000
x 1/3 =
$150,000

55. 15-55
Key Differences Between Revaluation /
Goodwill and Bonus Methods
Bonus Method
 Do not revalue the balance sheet.
 Only leaves the book value of
tangible net assets on the balance
sheet.
Book Value
of Net Assets

56. 15-56
Key Differences Between Revaluation /
Goodwill and Bonus Methods
Bonus Method
 Do not revalue the balance sheet.
 Only leaves the book value of
tangible 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

57. 15-57
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

58. 15-58
The Bonus Method
 Major Advantages
 Does not result in a departure from GAAP
 Minimizes bookkeeping and tax return effort
 Mechanics
 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!

59. 15-59
Determining the Value of Goodwill
Steps to follow:
1. Estimate the implied value of the partnership based on
the new partner’s contribution.
 New capital contribution ÷ new partner ownership %
2. Estimate the implied value of the partnership based on
the old partners’ total equity.
 Total old partner capital balance ÷ total old ownership %
3. Calculate the amount of tangible net assets.
 The sum of old partner capital and new partner contributed
capital.
4. Calculate implied goodwill
 Implied value (greater of 1 or 2) – tangible net assets (3)
5. Determine whether the new or old partners possess
goodwill.
 The smaller of 1 or 2
 The one who paid less for their relative share.

60. 15-60
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: the parent’s income is always
lower under the modified equity method.
a. $ 9,000
b. $54,000
c. $58,500
d. $60,000
e. $76,500

61. 15-61
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
a. $ 9,000.
b. $54,000.
c. $58,500.
d. $60,000.
e. $76,500.

62. 15-62
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
1. Calculate the firm’s total implied goodwill.
2. Prepare the entry or entries to record the
admission of Zoe.

63. 15-63
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 a total capital of $85,000.
REQUIRED
 Prepare the entry or entries to record the
admission of Mel.

64. 15-64
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
1. Prepare the required entries, assuming the land is to be revalued and the
goodwill is to be recorded on the partnership’s books.
2. Prepare the required entries, assuming that the bonus method is to be
used with respect to the undervalued tangible 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 tangible
assets. However, the next slide shows the calculation.

65. 15-65
Legal Aspects: Joining a Partnership
 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.

66. 15-66
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.

67. 15-67
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.

68. 15-68
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 was
20%. Partnership land was undervalued by
$50,000. The total partnership goodwill is
a. $ 4,000.
b. $20,000.
c. $24,000
d. $70,000.

69. 15-69
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
1. Prepare the entry to record the revaluation of assets to fair value.
2. Prepare the entry to record Sandy’s retirement.
3. What is the implicit total goodwill for the partnership?