Partnerships—Formation, Operations, and Changes in Ownership Interests

Partnerships—Formation, Operations, and Changes in Ownership Interests

1. Explain why the noncash investments of partners should be recorded at their fair values.

Noncash investments of partners should be recorded at their fair values in order to provide equitable treatment to the individual partners. The recording of noncash assets at less than fair value will result in allocating the amount of understatement between the partners in their relative profit and loss sharing ratios as the undervalued assets are used for partnership business or when they are sold by the partnership.

2. Is there a conceptual difference between partner drawings and withdrawals? Is there a practical difference?

Conceptually, there is no difference between the drawings and the withdrawals of partners since both represent disinvestments of resources from the partnership entity. From a practical viewpoint, the distinction between withdrawals and drawings may be important because allowable drawings are not usually deducted in determining the amount of partnership capital to be used for purposes of dividing profits among the partners. Since withdrawals are deducted, the distinction can affect the division of profits and losses.

3. In the absence of an agreement for the division of profits, how are they divided under UPA? Does your answer also apply to losses? Does it apply if one partner invests three times as much as the other partners?

In the absence of an agreement for dividing profits, an equal division among the partners is required by the Uniform Partnership Act. The agreement also applies to losses. And it applies irrespective of the relative investments by the partners.

4. Why do some profit-sharing agreements provide for salary and interest allowances?

Salary and interest allowances are included in some partnership agreements in order to reward partners for the time and effort that they devote to partnership business (salary allowances) and for capital investments (interest allowances) that they make in the business.

5. Are partner salary allowances expenses of the partnership?

Salary allowances to partners are not expenses of a partnership. Rather, they are a means of recognizing the efforts of individual partners in the division of partnership income.

6. When a profit-sharing agreement specifies that profits should be divided using the ratio of capital balances, how should capital balances be computed?

When profits are divided in the ratio of capital balances, capital balances should be computed on the basis of weighted average capital balances in the absence of evidence that another interpretation of capital balances is intended by the partners.

7. Explain how a partner could have a loss from partnership operations for a period even though the partnership had net income.

An individual partner may have a loss from his share of partnership operating activities even though the partnership has income. This situation results if priority allocations to other partners exceed partnership net income. For example, if net income for the A and B Partnership is $5,000 and profits are divided equally after a salary allowance of $8,000 to A, A will have partnership income of $6,500 and B will have a partnership loss of $1,500.

8. The concept of partnership dissociation has a technical meaning under the provisions of UPA. Explain the concept.

Partnership dissociation under the Uniform Partnership Act is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on of the business, as distinguished from the winding up of the business. Thus, the assignment of a partnership interest to a third party by one of the partners does not, by itself, dissolve the partnership because the assignee does not become a partner unless accepted as a partner by the continuing partners.

9. If a partner sells his or her partnership interest directly to a third party, the partnership may or may not be dissolved. Under what conditions is the partnership dissolved?

The sale of a partnership interest to a third party dissolves the old partnership if the continuing partners accept the third party purchaser as their partner. In this case, the relation among the partners is changed and a new partnership agreement is necessary.

10. How does the purchase of an interest from existing partners differ from the acquisition of an interest by investment in a partnership?

When a new partner acquires an interest by purchase from existing partners, the partnership receives no new assets because the payment for the new partner's interest is distributed to the old partners. Alternatively, an investment in a partnership increases the net assets of the partnership. This difference is important in accounting for the admission of a new partner.

11. What alternative approaches can be used in recording the admission of a new partner?

The admission of a new partner may be recorded by the goodwill approach (or revaluation approach) or by the bonus approach (or nonrevaluation approach).

12. Why is the goodwill procedure best described as a revaluation procedure?

The goodwill procedure for recording the admission of a new partner is best described as a revaluation approach because identifiable assets and liabilities that are over or undervalued are adjusted to their fair values before the unidentifiable asset goodwill is recorded. For example, if a new partner's investment reflects the fact that land owned by the old partnership is undervalued, it would be misleading to record the amount of revaluation as goodwill, rather than as a revaluation of the land account.

13. Explain the bonus procedure for recording an investment in a partnership. When is the bonus applicable to old partners, and when is it applicable to new partners?

A bonus procedure for recording an investment in a partnership involves adjusting the partnership capital account to the extent necessary to meet the new partnership agreement without a revaluation of the assets and liabilities of the old partnership.

If a new partner receives a capital credit in excess of his or her investment, the excess is a bonus to the new partner. A bonus to a new partner is charged against the old partners' capital balances in relation to their old profit sharing ratios.

If a new partner's investment exceeds his or her capital credit, the excess is a bonus to the old partners. A bonus to the old partners is credited to the old partners’ capital balances in accordance with the old partners' profit sharing ratios.

14. The goodwill procedure was used to record the investment of a new partner in the XYZ Partnership, but immediately thereafter, the entire business was sold for an amount equal to the recorded capital of the partnership. Under what conditions would the amounts received in final liquidation of the partnership have been the same as if the bonus procedure had been used?

The amounts received by the individual partners in final liquidation will be the same under the bonus and goodwill procedures provided that the relative profit and loss sharing ratios of the old partners remain unchanged in the new partnership and that the new partners' capital interest and profit and loss sharing ratio are aligned.

15. Bob invests $10,000 cash for a 25 percent interest in the capital and earnings of the BOP Partnership. Explain how this investment could give rise to (a) recording goodwill, (b) the write-down of the partnership assets, (c) a bonus to old partners, and (d) a bonus to Bob.

Parts a and b assume that the partnership assets are to be revalued upon the admission of Bob into the partnership.
Goodwill would be recorded if identifiable assets and liabilities are equal to their fair values and
1. $10,000 * 25% > $10,000 + old capital; or
2. Old capital * 75% > $10,000 + old capital; or
3. An independent assessment of earning power or other factors indicate goodwill.Old partnership assets would be written down if
1. $10,000 * 25% < $10,000 + old capital; or
2. Old capital * 75% < $10,000 + old capital; or
3. An independent assessment of earning power or other factors indicate that partnership assets are overvalued.
Parts c and d assume that partnership assets are not to be revalued upon the admission of Bob into the partnership. A bonus to the old partners would be recorded if 25% * ($10,000 + old capital) is less than $10,000. A bonus to Bob would be recorded if 25% * ($10,000 + old capital) is greater than $10,000.