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 $108,000 and equipment valued at $64,000 as well as $98,000 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 10 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 $8.000, 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 $9.000 annually or 15 percent of the beginning capital balance for the year, whichever is larger. The partnership reported a net loss of $8,000 during the first year of its operation. On January 1, 2017. Terri Dunn becomes a third partner in this business by contributing $21,000 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.

Answer 1

This is a partnership business. Here Rob has brought in tangible assets like building, equipments and cash into this business. Since all these are assets we would need to record this in the form a journal entry. The journal entry is mentioned below:

Date	Journal entry	Debit Amount (in $)	Credit Amount (in $)
01-Jan-2016	Buildings A/c	108,000
	Equipment A/c	64,000
	Cash A/c	98,000
	Capital - Steve Resse		135,000
	Capital- Rob O'Donnell		135,000

Here Rob O'Donnell's capital balance is $135,000 and he is entitled to 10% interest of the begining capital balance for the year. Interest is an expense for this business and his capital account will further be credited by this interest . So below is the journal entry for this transaction.

Interest Expense A/c DR $13,500

Capital - Rob O' Donnell CR 13,500

In 2016, this business incurred loss of $8,000 and there is no particular information on loss sharing ratio. So in absence of any concrete information, it is assumed that loss will be borne equally by both Steve and Rob. So both their capital accounts need to be reduced by $4,000 each. So updated Capital account balance for Steve would be $135,000 minus $4,000 which is $131,000. Rob O'donnell's capital account balance would be $135,000+$13,500-$4,000 which comes to $144,500.

So the total combined capital of both Rob & Steve is $131,000+144,500 which is $275,500. Now with the new partner Terri Dunn comes on board with a 20% share, the other partners (Rob & Steve) are left with 80% share. Since their 80% share of partnership capital must be equal to $275,500 after the admission of a new partner, the required capital after admission of a new partner would be equal to $275,500/80% which comes to $344,375.

Here the admission of Teri is not carried out at book value because the question is asking to account for the balance using two methods namely Goodwill method and Bonus method.

Goodwill Method ; Using the goodwill method, the capital allocated to the new partner must not be less than the amount invested and the capital accounts of the the existing partners must not be reduced. Here Teri invsted $21,000 in return for a 20% share in partnership. Existing Partner Capital is $275,500 plus $21,000 which comes to $296,500. Now the difference between paid in capital which is $296,500 and required capital which is $344,375 will be termed as goodwill. So the goodwill is $47,875. Since the new partner has paid less than what he should have paid, so entire amount of goodwill belongs to him.

So the journal entry under goodwill method would be as follows:

Cash A/c DR $21,000

Goodwill A/c DR $47,875

Capital - Terri Dunn CR $ 68,875

Bonus Method : Under this method, the total paid in capital would be $2,75,500+$21,000 which is $2,96,500 and the new partner would enjoy 20% share of partnership. So new partner capital would be 20% of $296,500 which is $59,300. New partner has invested $21,000 only and the difference is $21,000-$59,300 which comes to -$38,300. This minus $38,300 will be allocated to existing partners in proportion to their profit share ratio. It should be noted that the bonus in this case is a negative amount as the new partner Terri has invested less than the capital allocated. The existing partners must effectively absorb the bonus allocated as capital to the new partner. So journal entry under goodwill method would be as follows:

Cash A/c DR $21,000

Capital - Steve DR $19,175

Capital - Rob DR $19,175

Capital - Terri CR $59,300

Now it is easy to create journal entries for other transactions as we have identified what should be the capital balance of each partner in the starting of 2017.