Chapter 16

Partnerships –
Formation,
Operations, and
Changes in
Ownership
Interests
Interest allowance Weighted average method

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Admitting a New Partner
Methods of entry for a new partner into an
existing partnership:

1. New partner purchases interest from

existing partner(s).
• Goodwill method
• Bonus method
2. New partner invests directly in
partnership.
• Goodwill method
• Bonus method

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Investing in an existing partnership
New Partner Investment: Goodwill to Old Partners (Revalued)

Now assume that Dre and Boy, who have capital balances of
$40,000 each and share profits equally, agree to admit Cry to a
one-third interest in the capital and profits of a new partnership
for a cash investment of $50,000.
All three will have equal shares, and net assets are at fair value.
Goodwill will be recorded.

Implied value of firm, $50/(1/3) $150

Old capital, $40 + 40 $80
Additional investment 50 130
Goodwill $20

Cry: $130*1/3 = $43.3, but he pays $50 … so

goodwill goes to old partners. Implied firm value is
based on Cry's investment.
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New Partner Investment:
Goodwill to Old Partners (cont.)

Capital of $80 at the start, increases by the

$20 goodwill and the $50 cash investment.

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New Partner Investment:
Goodwill to Old Partners (cont.)

After re-
Before Re-valuation valuation Investment Final
Dre $40 $10 $50 $50
Boy 40 10 50 50
Cry $50 50
Total $80 $100 $150

Capital of $80 at the start, increases by the

$20 goodwill and the $50 cash investment.

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New Partner Investment: Bonus to Old Partners (Not Revalued)

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New Partner Investment:
Goodwill to New Partner (Revalued)
Dre and Boy each have capital balances of
$40 and share equally in the firm. Cry will
be admitted with an investment of $50 cash.
Cry will be given a 40% share; Dre and Boy
will each have 30%, and net assets are at
fair value. Goodwill will be recorded.
Implied value of firm, $80/(.60) $133.3
Old capital, $40 + 40 $80
Additional investment 50 130.0
Goodwill $3.3

Cry: $130*40% = $52, but he pays $50 … so goodwill goes to

new partner. Implied firm value is based on old partners' capital
and retained interest.
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New Partner Investment:
Goodwill to New Partner (cont.)

Re- After re-

Before valuation valuation Investment Final
Dre $40 $40 $40.0
Boy 40 40 40.0
Cry $3.3 3.3 $50 53.3
Total $80 $83.3 $133.3

Capital of $80 at the start, increases by the

$3.3 goodwill and the $50 cash investment.
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New Partner Investment:
Goodwill to New Partner (cont.)

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New Partner Investment: Bonus to new partner (Not Revalued)

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New Partner Investment: Bonus
Before Investment Bonus Final
Dre $40 ($1) $39
Boy 40 (1) 39
Cry $50 2 52
Total $80 $130

Cash 50
Dre Capital 1
Boy Capital 1
Cry Capital 52
Bonus method, bonus to new partner

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 Partnerships – Formation, Operations, and Changes in
Ownership Interests

5: DEATH OR RETIREMENT
OF A PARTNER

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Dissociation

Firm value, according to the Uniform

Partnership Act, is the greater of
• Liquidation value
• Sales value as a going concern without
the dissociated partner
Payment to exiting partner may be
• Equal to retiring capital
• More than retiring capital
- Implied goodwill or bonus to retire
partner
• Less than existing capital
- Write down overvalued assets, or
bonus to remaining partners

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Payment to Retiring Partner
Ann, Mic, and Jus are partners with capital
balances and profit-sharing percentages,
shown respectively, as follows:

Jus retires, and his partnership interest is

paid out by the partnership.

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Payment Equals Partner Capital

Jus Capital 80
Cash 80

The Ann, Mic, and Jus partnership would be

dissolved. Ann and Mic could continue the
partnership, but would need to establish a
new partnership agreement if a partner’s
retirement was not addressed in the original
partnership agreement.
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Payment Exceeds Partner Capital

If Jus is paid $92,000 in final settlement of

his partnership interest, the excess may be
treated as
1. A bonus to Jus, or
2. Goodwill, in the amount of the excess, or
3. A revaluation of partnership capital based
on the fair value implied by the excess.

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Excess Payment:
Bonus to Exiting Partner

Jus Capital 80
Ann Capital 8
Mic Capital 4
Cash 92

By treating the excess payment as a bonus

to Jus, Ann and Mic each have their capital
accounts reduced by their relative profit
sharing ratios of 40:20, for the total
amount of the $12,000 bonus amount.

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Excess Payment:
Goodwill Recorded

Jus Capital 80
Goodwill 12
Cash 92

By treating the excess payment as an

indication that partnership assets were
undervalued, Goodwill is recorded. Note
that Ann and Mic’s capital accounts are
not revalued.

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Excess Payment: Used to
Revalue Partnership Capital
Goodwill 30
Ann Capital 12
Mic Capital 6
Jus Capital 12

The excess payment is used to determine the

implied fair value of the partnership.
$12,000 excess / Jus’s 40% share =
implied partnership under-valuation of $30,000

Jus Capital 92
Cash 92
The exiting partner is then paid the amount of his
capital account.
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Payment less than capital balance

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 Partnerships – Formation, Operations, and Changes in
Ownership Interests

6: LIMITED
PARTNERSHIPS

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Limited Partnerships
Limited partnerships must have one or
more general partners with unlimited
liability for partnership debt.

There may be any number of limited

partners.
• Excluded from participating in
management
• Limited liability for partnership debt
• Partnership agreement must be in
writing, signed and filed

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