CHAPTER 14
PARTNERSHIPS: FORMATION AND OPERATION
Chapter Outline
I. Business organizations that are formed legally as partnerships, although they are not always
as visible as corporations, still proliferate throughout this country especially in the legal,
medical, and accounting professions.
A. Advantages of the partnership format include ease of creation and the absence of the
double taxation effect inherent to the income earned by a corporation and distributed to
its owners.
B. Partnerships, however, rarely grow to a significant size (when compared with large
corporate organizations) primarily because of the unlimited liability being assumed by
each general partner.
C. Alternative legal formats have been created over the years to combine the benefits of
corporations and partnerships such as S corporations, limited liability partnerships, and
limited liability companies.
II. Partnership accounting and the capital accounts
A. The distinctive aspects of partnership accounting center on the capital accounts
maintained for each individual partner.
B. The basis of accounting for these capital balances is the Articles of Partnership
agreement which establishes provisions for initial investments, withdrawals, admission of
a new partner, retirement of a partner, etc.
C. The actual contribution made by the partners to the business should be recorded at fair
market value. A problem arises, however, when a contribution is truly intangible such as
a particular expertise or an established client base.
1. In the bonus method, only identifiable assets are valued and recorded. The capital
account balances are then aligned to indicate the percentage of the actual
contributions being made by each partner.
2. In the goodwill method, the amount being contributed and the corresponding
percentage of the initial capital balance are used to calculate the value of the
business and the presence of goodwill, a figure which is physically recorded as an
intangible asset.
III. Partnership income allocation
A. At the end of each fiscal period, the revenue and expense accounts must be closed out
with the resulting income figure being assigned to the individual capital accounts.
B. The method of allocating income to the capital accounts should be established within the
Articles of Partnership.
1. The partners can simply assume an equal division of profits and losses.
2. The partners, however, can select any method that is designed to arrive at an
equitable allocation. Such factors as the amounts of capital invested, the time
worked in the business, and the degree of business expertise may all serve to
influence the assignment of income.
IV. Accounting for partnership dissolution
A. Over time, the identity of the individuals within a partnership can change through
admission of a new partner or the death, retirement, or withdrawal of a present partner.
B. Each change in composition serves to dissolve the original partnership usually so that a
new partnership can be formed to continue the business. Thus, dissolution does not
necessarily affect the operations of the business.
C. Admission of a new partner.
1. A new partner will often buy all (or a portion) of the interest owned by one or more of
the present partners.
a. The capital account balances can simply be reclassified to reflect the identity of
the new ownership.
b. As an alternative, all accounts may be adjusted to fair market value with the price
paid being used as the basis for calculating any goodwill.
2. A new partner can also be admitted by a direct contribution to the partnership
business.
a. The bonus (or no revaluation) method records the identifiable assets being
contributed at fair market value. The new partner’s capital is set equal to a
prearranged percentage or amount. The remaining capital balances are then
aligned based on profit and loss percentages.
b. The goodwill (or revaluation) approach initially adjusts all assets and liabilities of
the partnership to fair market value and records goodwill based on the amount
being paid (which is used to calculate the implied value of the business).
D. Withdrawal of a partner
1. The final asset distribution to an individual should be based on the agreement
established in the Articles of Partnership and will often vary in amount from that
partner’s ending capital balance.
2. The difference between the amount paid and the final capital balance can simply be
recorded as an adjustment to the remaining partners’ capital accounts in the same
manner as the bonus method.
3. As an alternative, all accounts can be adjusted to fair value with the amount of
payment being used as the basis for computing goodwill.
Answers to Discussion Questions
What kind of business is this?
The owners of this business face a common problem: they began operations without seriously
The accountant should discuss the following issues with the two owners:
—Ease of formation. A formal partnership can be created by the writing of an Articles of
Partnership. If income allocation and partners’ contributions are already determined, the
—Business liabilities. In a partnership, any partner may be held liable for all business debts.
Thus, if liabilities escalate and the business fails, each partner risks a large possible loss.
—Lawsuits. Some businesses are more susceptible to lawsuits than others. A florist, for
example, would likely have less risk than a pharmaceutical company. The concept of
personal liability for business debts becomes especially important when litigation risk is high.
—Taxation. In a partnership, all income is allocated to the owners immediately and they are
taxed on this amount. Double-taxation is avoided. A corporation pays an income tax and any
dividends are then taxed again when collected by the owners. Therefore, traditionally,
partnerships are viewed as having a tax advantage. The accountant should also mention to
the partners other possible tax factors that may affect their decision. For example, in small
Corporation—a business that is incorporated but still taxed as a partnership.
—Bankruptcy. If the business should ever fail and have to be liquidated, losses of a partnership
are passed directly to the owners to reduce taxable income immediately. For a corporation,
—Growth potential. Traditionally, corporations have more growth potential than do partnerships.
Ownership interests can be easily transferred. The limitation on liability encourages
Therefore, the accountant may want to address the following questions in advising these
clients:
What amount of time and energy is involved in becoming incorporated?
How much profit or loss is anticipated from the operations of this business in the
foreseeable future?
How much debt will the new business incur?
Will this debt be guaranteed by the owners?
How Will the Profits Be Split?
This case is designed to point up the difficulty of designing a profit-sharing arrangement that is
fair to all parties. Currently, these three individuals have incomes totaling an amount in excess
of the first year income that is expected. Thus, the adopted plan will have an immediate impact
Dewars has built up the firm and still handles the bigger clients although he plans to reduce his
workload over the next few years. Thus, one method of compensation would be to credit him
with interest on the capital built up in the business. However, if that number alone is used, it will
balance and $50 for each hour worked.
Huffman is contributing a significant number of hours to the firm but tends to work on the smaller
Scriba’s role is to develop a tax practice within the firm. Consequently, one suggestion would be
to credit her capital account with a percentage of the tax revenues (20 percent, for example)
Many answers to this question are possible. The above is just a simple suggestion based on the
facts presented in the case. Income allocation techniques are usually designed to reward the
Answers to Questions
1. The advantages of operating a business as a partnership include the ease of formation and
the avoidance of the double taxation effect that inherently reduces the profits distributed to
the owners of a corporation. In addition, because the losses of a partnership pass, for tax
purposes, directly through to the owners, partnerships have historically been used
(especially in certain industries) to reduce or defer income taxes.
Several disadvantages also accrue from the partnership format. Each general partner, for
example, has unlimited liability for all debts of the business. This potential liability can be
Question that appears above.
2. Specific partnership accounting problems center in the equity (or capital) section of the
balance sheet. In a corporation, stockholders’ equity is divided between earned capital and
3. The balance in each partner’s capital account measures that partner’s interest in the book
4. A Subchapter S corporation is formed legally as a corporation so that its owners enjoy
limited legal liability and easy transferability of ownership. However, if a company qualifies
Use of this designation is quite restricted. To qualify as a Subchapter S Corporation, a
company can only have one class of stock and must have no more than 100 owners. These
owners can only be individuals, estates, certain tax-exempt entities, and certain types of
trusts. Most corporations that do not qualify as Subchapter S Corporations are automatically
faces the double taxation effect commonly associated with corporations.
5. In a general partnership, each partner can have unlimited liability for the debts of the
business. Therefore, a partner may face a significant risk, especially in connection with the
actions and activities of other partners. However, general partnerships are easy to form and
often serve well in smaller businesses where all partners know each other. The major
A limited liability company can now be created in certain situations. This type of organization
is classified as a partnership for tax purposes so that the double-taxation effect is avoided.
6. The Articles of Partnership is a legal agreement that should be created as a prerequisite for
the formation of a partnership. This document defines the rights and responsibilities of the
partners in relation to the business and in relation to each other. Thus, it serves as a
governing document for the partnership. The Articles of Partnership may contain any
number of provisions but should normally specify each of the following:
a. Name and address of each partner
b. Business location
c. Description of the nature of the business
d. Rights and responsibilities of each partner
7. To give fair recognition to noncash contributions, all assets donated by the partners (such as
land or inventory) should be recorded by the partnership at their fair values at the date of
investment. However, for taxation purposes, the partner’s book value is retained.
8. In forming a partnership, one or more of the partners may be contributing some factor (such
as an established clientele or an expertise) which is not viewed normally as an asset in the
traditional accounting sense. In effect, the partner will be receiving a larger capital balance
than the identifiable contributions would warrant.
The bonus method of recording this transaction is to value and record only the identifiable
9. The Drawing account measures the amount of assets that a particular partner takes from
10. At the end of each fiscal year, when revenues and expenses are closed out, some
assignment must be made of the resulting income figure Because a partnership will have
11. The allocation process can be based on any number of factors. The actual assignment of
income should be designed to give fair and equitable treatment to each of the partners.
12. If agreement as to the allocation of income has not been specified, an equal division among
13. The dissolution of a partnership is the breakup or cessation of the partnership. Many
reasons can exist for a partnership to dissolve. One partner may withdraw, retire, or die. A
14. A new partner can join a partnership by acquiring part or all of the interest of one or more of
the present partners. This transaction is carried out with the individual partners directly and
15. In selling an interest in a partnership, three rights are conveyed to the new owner:
a. The right of co-ownership of the business property;
16. Goodwill recognized in a capital transaction is allocated to the original partners based on the
profit and loss ratio. The amount is assumed to represent unrealized gains in the value of
17. Allocating goodwill to an entering partner may be necessary for several reasons. One of the
most common is that the partner is bringing to the partnership an attribute that is not an
asset in the traditional accounting sense. For example, a new partner with an excellent
18. Book values in most cases measure historical cost expenditures which often have
undergone years of allocation and changes in value. For this reason, book value will
frequently fail to mirror or even resemble the actual worth of a business. In addition, the
Answers to Problems
4. C Mary Ann’s investment equals 1/3 of total capital ($50,000 ÷ $150,000).
However, she receives only a 1/4 interest capital balance. One explanation
5. D Based on the new contribution, the company’s implied value is $350,000
($105,000 ÷ 30%) which is less than the capital balances ($315,000 in
original capital plus $105,000 to be invested). Thus, either the assets are
overvalued or the new partner is contributing goodwill in addition to a cash
6. B The implied value of the company is $960,000 ($240,000 ÷ 25%). Because
the current capital total is only $760,000, goodwill of $200,000 must be
7. B Total capital is $200,000 ($110,000 + $40,000 + $50,000) after the new
investment. As Kansas’s portion is 30 percent, the capital balance becomes
$60,000 ($200,000 × 30%). Because only $50,000 was paid, a bonus of
bonus of $10,000 is being given to the two original partners based on their
profit and loss ratio: Messalina – $6,000 (60%) and Romulus – $4,000 (40%).
The increase raises Messalina’s capital balance from $210,000 to $216,000
and Romulus’s capital balance from $140,000 to $144,000.
10.D ASSIGNMENT OF INCOME
ALFRED BERNARD COLLINS TOTAL
Interest—5% of
beginning capital ................. $ 2,500 $ 3,000 $ 3,500 $ 9,000
Allocation of remaining income
($33,000 divided on a 3:3:4 basis) 9,900 9,900 13,200 33,000
Totals ……………….….…... $12,400 $30,900 $16,700 $60,000
STATEMENT OF CAPITAL
ALFRED BERNARD COLLINS TOTAL
Beginning capital ……….….…... $50,000 $60,000 $70,000 $180,000