15 Partnerships: Formation, Operation, and Changes in Membership McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc All rights reserved Overview • Accounting for partnerships requires 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 15-2 Nature of Partnership Entity • Legal regulation – 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 15-3 Nature of Partnership Entity • Definition of a partnership – 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 ” 15-4 Nature of Partnership Entity • Definition of a partnership – – – 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 15-5 Nature of Partnership Entity • Formation of a partnership – Easy to form – The agreement to form a partnership may be informal or formal – Each partner must agree to the formation agreement, and partners are strongly advised to have a formal written agreement to avoid potential problems later 15-6 Nature of Partnership Entity • Other major characteristics – 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 15-7 Nature of Partnership Entity • Other major characteristics – 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 15-8 Nature of Partnership Entity • Other major characteristics – 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 15-9 Nature of Partnership Entity • Other major characteristics – 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 15-10 Changes in Membership • Retirement or withdrawal of a partner from a 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 15-25 Changes in Membership – General concepts • The partnership as an entity separate from 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 15-26 Changes in Membership – General concepts • Recognizing decreases in net asset revaluations – – – – 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 15-27 Changes in Membership – General concepts • Bonus method – 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 15-28 Changes in Membership – General concepts • The partnership as an aggregate of partners’ interests and the use of non-GAAP accounting – Partners may use non-GAAP accounting methods that meet their information needs 15-29 Changes in Membership – General concepts • Recognizing increases in net asset revaluations or goodwill – 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 15-30 New Partner Invests in Partnership • Step 1: The first step is to compute the new partner’s proportion of the partnership’s book value: 15-31 New Partner Invests in Partnership • Step 2: Determine the specific admission 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 15-32 New Partner Invests in Partnership 15-33 New Partner Invests in Partnership • Determining a new partner’s investment cost – It is important to note the total resulting capital of the partnership and the percentage of ownership interest retained by the prior partners 15-34 Dissociation of a Partner • • In most cases, the partnership purchases the dissociated partner’s interest in the partnership for a buyout price The buyout price is the estimated amount if: – – 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 15-35 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 15-36 Dissociation of a Partner • Buyout price equal to partner’s capital credit – If the partnership is unable to pay the amount at the time of retirement, it must recognize a liability for the remaining portion 15-37 Dissociation of a Partner • Buyout price greater than partner’s capital credit – – 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 15-38 Dissociation of a Partner • Buyout price less than partner’s capital 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 15-39 ... 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 15- 15 Accounting. .. obligations 15- 13 Nature of Partnership Entity • Accounting and financial reporting requirements for partnerships – For internal reporting needs, non-GAAP accounting methods may be used and financial. .. required under GAAP – To issue general-purpose financial statements for external users, generally accepted accounting principles should be used 15- 14 Accounting for the Formation of a Partnership