Question

Steve Reese is a well-known interior designer in Fort Worth, Texas. He wants to start his own business and convinces Rob O’Donnell, a local merchant, to contribute the capital to form a partnership. On January 1, 2016, O’Donnell invests a building worth $124,000 and equipment valued at $128,000 as well as $48,000 in cash. Although Reese makes no tangible contribution to the partnership, he will operate the business and be an equal partner in the beginning capital balances.

To entice O’Donnell to join this partnership, Reese draws up the following profit and loss agreement:

• O’Donnell will be credited annually with interest equal to 20 percent of the beginning capital balance for the year.
• O’Donnell will also have added to his capital account 10 percent of partnership income each year (without regard for the preceding interest figure) or $6,000, whichever is larger. All remaining income is credited to Reese.
• Neither partner is allowed to withdraw funds from the partnership during 2016. Thereafter, each can draw $7,000 annually or 15 percent of the beginning capital balance for the year, whichever is larger.

The partnership reported a net loss of $11,000 during the first year of its operation. On January 1, 2017, Terri Dunn becomes a third partner in this business by contributing $19,000 cash to the partnership. Dunn receives a 20 percent share of the business’s capital. The profit and loss agreement is altered as follows:

• O’Donnell is still entitled to (1) interest on his beginning capital balance as well as (2) the share of partnership income just specified.
• Any remaining profit or loss will be split on a 5:5 basis between Reese and Dunn, respectively.

Partnership income for 2017 is reported as $94,000. Each partner withdraws the full amount that is allowed.

On January 1, 2018, Dunn becomes ill and sells her interest in the partnership (with the consent of the other two partners) to Judy Postner. Postner pays $145,000 directly to Dunn. Net income for 2018 is $94,000 with the partners again taking their full drawing allowance.

On January 1, 2019, Postner withdraws from the business for personal reasons. The articles of partnership state that any partner may leave the partnership at any time and is entitled to receive cash in an amount equal to the recorded capital balance at that time plus 10 percent.

1. Prepare journal entries to record the preceding transactions on the assumption that the bonus (or no revaluation) method is used. Drawings need not be recorded, although the balances should be included in the closing entries.

2. Prepare journal entries to record the previous transactions on the assumption that the goodwill (or revaluation) method is used. Drawings need not be recorded, although the balances should be included in the closing entries.

Answer 1

a.

12/31/13

(The allocation plan specifies that O'Donnell receives 20% in interest [or $12,000 based on $60,000 capital balance] plus $8,000 more [Because that amount exceeds 10% of the profits from the period]. The remaining $29,000 loss is assigned to Reese.)

1/1/14

O'Donnell, Capital (10%) = $1,420

Reese, Capital (90%) = $12,780

(New investment by Dunn brings total capital to $121,000 after 2013 loss [$120,000 − $9,000 + $10,000]. Dunn's 20% interest is $24,200 [$121,000 × 20%] with the extra $14,200 coming from the two original partners [allocated between them according to their profit and loss ratio].)

12/31/14

(To close out drawings accounts for the year based on distributing 15% of each partner's beginning capital balances [after adjustment for Dunn's investment] or $5,000 whichever is greater. O'Donnell's capital is $78,580 [$60,000 + $20,000 − $1,420])

12/31/14

(To allocate $85,000 income figure for 2014 as determined below.)

	O'Donnell		Reese		Dunn
Interest (20% of $78,580     beginning capital balance)	$	15,716
10% of $85,000 income		8,500
50:50 spilt of remaining $60,784 income			$	30,392	$	30,392
Total	$	24,216	$	30,392	$	30,392

Capital Balances as of December 31, 2014:

	O'Donnell			Reese			Dunn
Initial 2013 investment	$	60,000		$	60,000
2013 profit allocation		20,000			(29,000	)
Dunn's investment		(1,420	)		(12,780	)	$	24,200
2014 drawings		(11,787	)		(5,000	)		(5,000	)
2014 profit allocation		24,216			30,392			30,392
12/31/14 balances	$	91,009		$	43,612		$	49,592

12/31/15

(To allocate profit for 2015 determined as follows)

	O'Donnell		Reese		Postner
Interest (20% of $91,009 beg. capital)	$	18,202
10% of $65,000 income		6,500
50:50 spilt of remaining $40,298			$	20,149	$	20,149
Totals	$	24,702	$	20,149	$	20,149

1/1/16

O'Donnell, Capital (10%) = $623

Reese, Capital (90%) = $5,607

(Postner's capital is $62,302 [$49,592 − $7,439 + $20,149]. Extra 10% payment is deducted from the two remaining partners' capital accounts.)

b.

1/1/13

(To record initial capital investments. Reese is credited with goodwill of $120,000 to match O'Donnell's investment.)

12/31/13

(Interest of $24,000 is credited to O'Donnell [$120,000 × 20%] along with a base of $8,000. The remaining amount is now a $41,000 loss that is attributed entirely to Reese.)

1/1/14

(Cash and goodwill being contributed by Dunn are recorded. Goodwill must be calculated algebraically.)

$10,000 + Goodwill =	20% (Current Capital + $10,000 + Goodwill)
$10,000 + Goodwill =	20% ($231,000 + $10,000 + Goodwill)
$10,000 + Goodwill =	$48,200 + 0.20 Goodwill
0.80 Goodwill =	$38,200
Goodwill =	$47,750

12/31/14

(To close out drawings accounts for the year based on 15% of beginning capital balances: O'Donnell—$152,000, Reese—$79,000, and Dunn—$57,750.)

12/31/14

(To allocate $85,000 income figure as follows)

	O'Donnell		Reese		Dunn
Interest (20% of $152,000     beginning capital balance)	$	30,400
10% of $85,000 income		8,500
50:50 spilt of remaining $46,100			$	23,050	$	23,050
Totals	$	38,900	$	23,050	$	23,050

Capital balances as of December 31, 2014:

	O'Donnell			Reese			Dunn
Initial 2013 investment	$	120,000		$	120,000
2013 profit allocation		32,000			(41,000	)
Additional investment							$	57,750
2014 drawings		(22,800	)		(11,850	)		(8,663	)
2014 profit allocation		38,900			23,050			23,050
12/31/14 balances	$	168,100		$	90,200		$	72,137

1/1/15

O'Donnell, Capital (10%) = $1,747

Reese, Capital (45.0%) = $7,863

Dunn, Capital (45.0%) = $7,863

(To record goodwill indicated by purchase of Dunn's interest.)

In effect, profits are shared 10% to O'Donnell, 45.0% to Reese – (50% of the 90% remaining after O'Donnell's income), and 45.0% to Dunn (50% of the 90% remaining after O'Donnell's income). Postner is paying $80,000, an amount $7,863 in excess of Dunn's capital ($72,137). The additional payment for this 45.0% income interest indicates total goodwill of $17,473 ($7,863 ÷ 45.0%). Because Dunn is entitled to 45.0% of the profits but only holds 22% of the total capital, an implied value for the company as a whole cannot be determined directly from the payment of $80,000. Thus, goodwill can only be computed based on the excess payment.

12/31/15

(To close out drawings accounts for the year based on 15% of beginning capital balances [after adjustment for goodwill].)

12/31/15

To allocate profit for 2015 as follows:

  

	O'Donnell		Reese		Postner
Interest (20% of $169,847     beginning capital balance)	$	33,969
10% of $65,000 income		6,500
50:50 spilt of remaining $24,531			$	12,266	$	12,266
Total	$	40,469	$	12,266	$	12,266

  

Capital Balances as of December 31, 2015:

  

	O'Donnell			Reese			Postner
12/31/14 balances	$	168,100		$	90,200		$	72,137
Adjustment for goodwill		1,747			7,863			7,863
Drawings		(25,477	)		(14,709	)		(12,000	)
Profit allocation		40,469			12,266			12,266
12/31/15 balances	$	184,839		$	95,620		$	80,266

  

Postner will be paid $88,293 (110% of the capital balance) for her interest. This amount exceeds her capital balance by $8,027. Because Postner is only entitled to a 45.0% share of profits and losses, the additional $8,027 indicates that the partnership as a whole is undervalued by $17,838 (8,027 ÷ 45.0%). Only in that circumstance is the extra payment to Postner justified:

  

1/1/16

O'Donnell, Capital (10%) = $1,784

Reese, Capital (45.0%) = $8,027

Postner, Capital (45.0%) = $8,027

  

(To recognize implied goodwill.)

1/1/16

Postner's 12/31/15 balance $80,266 × 110% = $88,293