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CHANGES IN PARTNERSHIPPartnership Dissolution (Changes in Ownership) Partnership dissolution occurs whenever there is a change in ownership (e., the addition of a new partner, or the retirement, withdrawal or death of an existing partner). We will also include in this handout the incorporation of a ...

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! CHANGES IN PARTNERSHIP Partnership Dissolution (Changes in Ownership) Partnership dissolution occurs whenever there is a change in ownership (e.g., the addition of a new partner, or the retirement, withdrawal or death of an existing partner). We will also include in this handout the incorporation of a partnership, that is, change from a partnership form of organization to a corporation. Partnership dissolution should not be confused with partnership liquidation which is the winding up of partnership affairs and termination of the business. Under dissolution the partnership business continues, but under different ownership. When partnership dissolution occurs, a new accounting entity exists. The partnership should first adjust its records so that all accounts are properly stated at the date of dissolution. After the income (loss) has been properly allocated to the existing partners’ capital accounts, all assets and liabilities should be adjusted to their fair market value and their present values, respectively. The latter step is performed because the dissolution results in a new accounting entity. After all adjustments have been made, the accounting for dissolution depends on the type of transaction that caused the dissolution. These transactions can be broken down into two types: * Transactions between the partnership and a partner (e.g., a new partner contributes assets, or a retiring partner withdraws assets). * Transactions between partners (e.g., a new partner purchases an interest from one or more existing partners, or a retiring partner sells his/her interest to one or more existing partners). a. Transactions Between a Partner and the Partnership (1) Admission of a New Partner When a new partner is admitted to the partnership essentially three cases can result. The new partner can invest assets into the partnership and receive a capital balance. (a) Equal to his/her purchase price. (b) Greater than his/her purchase price. (c) Less than his/her purchase price. If the new partner’s capital balance is equal to the assets invested, then the entry debits the asset(s) contributed and credits the new partner’s capital account for the fair value of the asset(s) contributed. If the new partner’s capital balance is not equal to the assets invested (as in situation (b) and (c) above), then either the bonus or goodwill method must be used to account for the difference. Bonus method - The old partnership capital plus the new partner’s asset contribution is equal to the new partnership capital. The new partner’s capital is allocated his purchase share (e.g., 40%) and the old partner’s capital accounts are adjusted as if they had been paid (or as if they paid) a bonus. The adjustment to the old partners’ capital accounts is made in accordance with their profit (loss) sharing ratio. The bonus method implies that the old partners either received a bonus from the new partner, or they paid a bonus to the new partner. As a result the old partners’ capital accounts are either debited to reflect a bonus paid, or credited to reflect a bonus received. The new partner’s capital account is never equal to the amount of assets contributed in a case where the bonus method is used. Goodwill method - The old partnership capital plus the new partner’s asset contribution is not equal to the new partnership capital. This is because goodwill is recorded on the partnership books for the difference between the total identifiable assets of the partnership (not including goodwill) and the deemed value of the partnership entity (which includes goodwill). An adjustment is made to the capital accounts of the existing partners to reflect the goodwill (whether acquired or given) in their profit (loss) sharing ratio. Under the goodwill method, valuation of the partnership is the objective. 10

! How the value of the partnership is determined depends on whether the book value acquired is greater or less than the asset(s) invested. If the book value acquired is less than the asset(s) invested, the value is determined based upon the new partner’s contribution, and goodwill is allocated to the old partners’ accounts. If the book value acquired is greater than the asset(s) contributed, the value is based upon the existing capital accounts, and goodwill is attributed to the new partner. Example: A & B Partnership admit C by investing to the business P50,000 for a 1/5 interest. The capital balances of A and B before the admission are P100,000 and P80,000, respectively. The goodwill can be determined as follows: Total contributed capital to the business (100,000 + 80,000 + 50,000) P230,000 Capital interest of C the new partner x 1/5 Book value of the interest acquired P 46,000 The assets contributed is greater than the book value acquired, therefore the total implied capital must be based on the new partner’s contribution which is P50,000. The total implied capital in this case must be P250,000, (50,000 ÷ 1/5). The goodwill must be P20,000 to old partners. (250,000 – 230,000). Assuming that the interest of C will be ¼, then the book value acquired must be P57,500, (230,000 x ¼), greater than the assets contributed by C, then the total implied capital must be based on the old partners’ contributions which is P180,000. The implied total capital must be P240,000, (180,000 ÷ ¾). The goodwill in this case must be P10,000, (240,000 – 230,000) and the goodwill will now be given to the new partner. So, it is just like bonus method. In the above example wherein the interest of C is 1/5, the bonus goes to the old partners, but inasmuch as no bonus recognized but rather goodwill then the goodwill goes to the old partners. In the situation wherein C’s interest is ¼ the bonus goes to the new partner but under the goodwill method, then goodwill and not bonus to new partner. You can also determine the goodwill by simply dividing the contributed capital of old partners to their capital interest and also the contributed capital of the new partner to his/her capital interest. The amount that was computed which is greater than the total contributed capital would be the implied or deemed total capital. The goodwill must be the difference between the total implied or deemed capital over the total contributed capital. If the total implied capital was based on the old partners’ contribution then goodwill must be given to the new partner, but if the total implied capital is based on the new partner’s contribution then the goodwill must be given to the old partner. Using the same example above, C’s interest is 1/5, then total implied capital of business can be determined as follows: Capital contributed by old partners or new partner divide by their interest whichever is higher then that should be the total implied capital. Capital balances of A & B P180,000 Capital contributed by C P 50,000 Interest of A & B ÷ 4/5 Interest of C ÷ 1/5 Implied total capital P225,000 Implied total capital P250,000 The amount greater than the total contributed capital must be the total implied capital which is P250,000. Therefore, if the basis of the agreed capital is the contribution of the new partner, then the goodwill of P20,000 must be credited to the old partners. Try it to C’s ¼ interest and you will arrive at the same conclusion that this time the goodwill goes to the new partner. The decision as to whether the bonus or goodwill method should be used rests with partners involved. In other words, the bonus and goodwill methods are alternative solutions to the same problem. For CPA Board exam, if the method is not clearly indicated in the problem then the generally acceptable and preferable method must be the bonus method. 11

! Example: Admission of a New Partner - Bonus Method Total old capital for ABC Partnership is P600,000. Partner A B C Capital Balances P100,000 P200,000 P300,000 P&L Ratio 40% 40% 20% Case I D is admitted to the partnership and is given a 20% interest in the capital in return for a cash contribution of P300,000. The entry to record the admission of D should be Cash P300,000 D, capital P180,000 A, capital 48,000 B, capital 48,000 C, capital 24,000 The total partnership capital to be shown on the books is P900,000 (P600,000 + P300,000) of which D is entitled to a 20% interest, or a capital balance of P180,000. The remaining P120,000 is treated as a bonus to the old partners and is allocated to their capital accounts in accordance with their P&L ratio. Case 2 D is admitted to the partnership and is given a 20% interest in the capital in return for a cash contribution of P100,000. The entry to record the admission of D in this case should be Cash P100,000 A, capital 16,000 B, capital 16,000 C, capital 8,000 D, capital P140,000 The total partnership capital to be shown on the books is P700,000 (P600,000 + P100,000) of which D is admitted to a 20% interest, or a capital balance of P140,000. The difference of P40,000 (P100,000 - P140,000) is allocated to the old partners’ capital accounts as if they had paid a bonus to the new partner. Example: Admission of a New Partner - Goodwill Method Use the same original data as given above Case I D is admitted to the partnership and is given a 20% interest in the capital in return for a cash contribution of P200,000. The partners elect to record goodwill. The book value acquired (P600,000 + P200,000) x 20% = P160,000 is less than the asset contributed. The value of the partnership is determined based upon the contribution of the new partner. In this case it is assumed that the partnership value is P1,000,000 (P200,000/20%). The resulting goodwill is P200,000 (P100,000 - P800,000). The P800,000 represents the total current capital exclusive of goodwill, P600,000 of which is attributable to the old partners and P200,000 of which is attributable to the new partner. The entry to record the admission of D should be: Goodwill P200,000 Cash P200,000 A, capital P80,000 D, capital P200,000 B, capital 80,000 C, capital 40,000 Goodwill was allocated to the old partners in their P&L ratio. Also note that the capital balance of D represents 20% of the total capital of the partnership. Case 2 D is admitted to the partnership and is given a 20% interest in the capital in return for a cash contribution of P100,000. The partners elect to record goodwill. The book value acquired (P600,000 + P100,000) x 20% = P140,000 is greater than the asset contributed. The partnership value is based upon the capital accounts of the existing partners. Because D is entitled to a 20% interest, the P600,000 capital of the old partners must represent 80% of the 12

! capital. This means that the total value of the partnership is P750,000 (P600,000/80%). D’s total contribution consists of the P100,000 in cash and P50,000 of goodwill. The goodwill is determined as the difference between the cash contribution and the 20% of the partnership capital. Cash Goodwill D, capital

P100,000 50,000 P150,000

Note that in this last case no adjustment is made to the capital accounts of partners A, B, and C To summarize the above explanations, under the goodwill method, goodwill can be determined by simply dividing the capital contributions of either the new partner or the old partners, to get an amount higher than the total contributed capital. The higher amount is now called the total implied capital after goodwill or otherwise known as total agreed capital. The total agreed capital is then compared to the total contributed capital to get the total amount of implied goodwill that should be recognized in the books. If the new partner’s contribution was used to get the total agreed capital, then goodwill should be credited to the old partners’ capital in accordance with their P&L ratio. But if the old partners’ capital was used to get the agreed capital then goodwill should be credited to the new partner’s capital. The table below summarizes the bonus and goodwill situations discussed above: When to Apply Bonus Method New Partnership Capital = Old Partners Capital + New Partner’s Asset Investment Which Partner(s) Receive Bonus New Partner New Partner’s Capital Credit > New Partner’s Asset Investment Old Partners New Partner’s Capital Credit < New Partner’s Asset Investment (The difference represents the bonus allocated to old partners in their P&L ratio.) When to Apply Goodwill Method New Partnership Capital > Old Partners Capital + New Partner’s Asset Investment Which Partner’s Goodwill is Recognized New Partner’s Goodwill New Partner’s Capital Credit > New Partner’s Asset Investment (The difference represents goodwill) Old Partners’ Goodwill New Partner’s Capital Credit = New Partner’s Asset Investment (Goodwill is allocated to old partners in their P&L ratio) Total Capital Agreed After Admission Sometimes partners agreed as to the total capital of the partnership after the admission of a new partner that might either result in: (1) goodwill to old partners only or new partner only or both, or (2) bonus to old partners only or new partner only but it can never be both, or (3) goodwill and bonus to either old partners or new partner. Situations wherein goodwill to old partners only or new partners only and bonus to old partners only or new partner only were already discussed above except that the total agreed capital was not specified in the example. It was assumed using the bonus method or goodwill method. Cases explained below pertain to situations wherein goodwill and at the same time bonus were either credited to old partners’ capital based on their P&L ratio or to new partner’s capital.

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! Case 1 Using the previous example for ABC Partnership, wherein D invested P300,000, but this time all partners agreed that the total capital after D’s admission should be P1,000,000 and D’s interest in the partnership net assets is 20%. The partnership should therefore recognized goodwill of P100,000 (P1,000,000 agreed capital minus P900,000 contributed capital; P600,000 attributable to old partners and P300,000 attributable to new partner). D should be credited for P200,000 (P1,000,000 x 20%) only, inspite of his contribution of P300,000. Therefore, the old partners in this case should receive the goodwill of P100,000 and the bonus from the new partner of P100,000 distributed based on their P&L ratio. The entry to record the admission of D should be: Goodwill A, capital B, capital C, capital

P100,000 P40,000 40,000 20,000

Cash

P300,000 D, capital P200,000 A, capital 40,000 B, capital 40,000 C, capital 20,000

Case 2 Using the previous example in case 1 above, except, this time D invested P250,000, and all partners agreed that the total capital after D’s admission should be P900,000 and D’s interest in the partnership’s net assets is 40%. The partnership should recognized goodwill of P50,000 (P900,000 agreed capital minus P850,000 contributed capital). D should be credited for P360,000 (40% x P900,000). If the capital credit to D is P360,000 but his capital contribution is just P250,000, then the goodwill of P50,000 should be credited to him as well as a bonus of P60,000 from the old partners (to make the total capital of D P360,000) deducted from them based on their P&L ratio. The entry to record the admission of D should be: Goodwill P50,000 A, capital P24,000 D, capital P50,000 B, capital 24,000 Cash P250,000 C, capital 12,000 D, capital P250,000 D, capital P60,000 Case 3 Using again the above example in case 1 and this time D invested P200,000 but he should be credited for P250,000 a 25% interest in the partnership net assets. The partners also agreed that the total capital should be P1,000,000 after D’s admission. The goodwill therefore in this case is P200,000 (P1,000,000 agreed capital minus P800,000 contributed capital), and D should be credited for P250,000 (25% x P1,000,000). Inasmuch as the amount of identifiable assets contributed by D is just P200,000, but he should be credited for P250,000, then it is implied that D is bringing in goodwill of P50,000. Therefore, the goodwill should be distributed as follows: P50,000 to D and the balance of P150,000, is the implied goodwill of the business prior to D’s admission and should be credited to old partners based on their P&L ratio. The entry to record D’s admission should be Goodwill P200,000 Cash P200,000 A, capital P60,000 D, capital P200,000 B, capital 60,000 C, capital 30,000 D, capital 50,000 Partner’s Interest Different From P&L Sharing Ratio Normally, the partner’s interest in the partnership’s net assets is equal to his or her P&L ratio. If in case, the interest in net assets differs from the share in the profit or loss of the partnership, then 14

! the use of either bonus method or the goodwill method might be advantageous to the new partner in recording his or her admission. Example: Interest Greater Than P&L Ratio Case 1 Using the same information of ABC Partnership above except that D was admitted into the partnership for a 25% interest and D’s P&L ratio is only 20%, after investing P300,000. Using the bonus method D should be credited for P225,000 (P900,000 x 25%) and based on this you can now say that D, the new partner is giving bonus to old partners of P75,000 (P300,000 P225,000), distributed to A, B & C based on their P&L ratio. Using the goodwill method, D’s capital contribution will be the basis of computing the agreed capital of P1,200,000 (P300,000/25%). The goodwill of P300,000 (P1,200,000 - P900,000) will be credited to old partners based on their P&L ratio. Under the goodwill method, the goodwill determined is normally recorded in the books. The goodwill once recorded in the books should be written off for a period of not exceeding 40 years (GAAP rule) and thus the effect is reduction in the capital of all partners. Since D’s P&L ratio is just 20%, D’s share on the goodwill amortization would be P60,000 (20% x P300,000), and D’s capital will reduce to P240,000. Therefore, it will be advantageous for D to use the goodwill method because the capital is still P240,000, rather than the bonus method wherein the capital is only P225,000, and the advantage will be P15,000, or to simplify the computation, just get the difference between the interest and P&L share, then multiply by the amount of goodwill. (25% - 20%) = 5% of P300,000 goodwill. To summarize the above explanations the following computations were made. Bonus method: Capital credit to D (25% x P900,000 agreed capital) P225,000 Goodwill method: Capital credit to D initially (25% x P1,200,000) equal to his capital contribution P300,000 Less: Share on the goodwill amortization (20% x P300,000) 60,000 240,000 Advantage of goodwill method over bonus method P 15,000 OR simply the difference between the interest and P&L multiply by the goodwill recognized under the goodwill method. (5% x P300,000) = P15,000. Example: Interest Less Than P&L Ratio Case 2 Using the same information, but this time the interest is 20% and D’s P&L ratio is 25%. Bonus method: Capital credit to D (20% x P900,000) P180,000 Goodwill method: Capital credit to D (20% x P1,500,000) P300,000 Less: Share on the goodwill amortization (25% x P600,000) 150,000 150,000 Advantage of Bonus method over Goodwill method P 30,000 OR simply the difference between the interest and P&L multiply by the goodwill recognized under the goodwill method (5% x P600,000) = P30,000. The table below summarizes the situations discussed above. Bonus method advantageous and the amount of advantage. Partner’s interest in the net assets < Partner’s P&L ratio, difference x Goodwill. Goodwill method advantageous and the amount of advantage Partner’s interest in the net assets > Partner’s P&L ratio, difference x Goodwill. 15

! Neither bonus nor goodwill advantageous (general rule) Partner’s interest in the net assets = Partner’s P&L ratio, difference x Goodwill.

(2) Partner Death or Withdrawal or Retirement The death or withdrawal or retirement of a partner is treated in much the same manner as the admission of a new partner. However, there is no new capital account to be recorded; we are dealing only with the capital accounts of the original partners. Either the bonus or goodwill method may be used. The key thing to remember in regard to a partner’s withdrawal from the partnership is that the withdrawing partner’s capital a...