Steve Reese is a well-known interior designer in Fort Worth, Texas. He wants to

ID: 2512011 • Letter: S

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 $60,000 and equipment valued at $32,000 as well as $28,000 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 $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 $5,000 annually or 15 percent of the beginning capital balance for the year, whichever is larger.

The partnership reported a net loss of $9,000 during the first year of its operation. On January 1, 2017, Terri Dunn becomes a third partner in this business by contributing $10,000 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 $85,000. 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 $80,000 directly to Dunn. Net income for 2018 is $65,000 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.

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.

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.

Explanation / Answer

Date

General journal

Debit

Credit

01/01/2016

Building

60000

Equipment

32000

Cash

28000

O’Donnell Capital

60000

Reese Capital

60000

12/31/2016

Reese Capital

29000

O’Donnell Capital

20000

Income summary

9000

01/01/2017

Cash

10000

O’Donnell Capital

1420

Reese Capital

12780

Dunn Capital

24200

12/31/2017

O’Donnell Capital

11787

Reese Capital

5000

Dunn Capital

5000

O’Donnell drawings

11787

Reese drawings

5000

Dunn drawings

5000

12/31/2017

Income summary

85000

O’Donnell Capital

24216

Reese Capital

30392

Dunn Capital

30392

01/01/2018

Dunn Capital

49592

Postner Capital

49592

12/31/2018

O’Donnell Capital

13651

Reese Capital

6542

Postner Capital

7439

O’Donnell drawings

13651

Reese drawings

6542

Postner drawings

7439

12/31/2018

Income summary

65000

O’Donnell Capital

24702

Reese Capital

20149

Postner Capital

20149

01/01/2019

O’Donnell Capital

62302

Dunn Capital

623

Reese Capital

5607

Cash

68532

Explanation:

12/31/2016

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.

01/01/2017

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].

12/31/2017

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].

12/31/2017

To allocate $85,000 income figure for 2017 as determined below.

O’Donnell

Reese

Dunn

Interest (20% of $78,580
beginning capital balance)

15716

10% of $85,000 income

8500

50:50 spilt of remaining $60,784 income

30392

Total

$24216

$30392

Capital Balances as of December 31, 2017:

O’Donnell

Reese

Dunn

Initial 2016 investment

$60000

2016 profit allocation

20000

(29000)

Dunn's investment

(1420)

(12780)

24200

2017 drawings

(11787)

(5000)

2017 profit allocation

24216

30392

12/31/2017 balances

$91009

$43612

$49592

12/31/2018

To allocate profit for 2018 determined as follows:

O’Donnell

Reese

Postner

Interest (20% of $91009
beginning capital balance)

18202

10% of $65000 income

6500

50:50 spilt of remaining $40298 income

20149

Total

24702

20149

01/01/2019

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.

Date

General journal

Debit

Credit

01/01/2016

Building

60000

Equipment

32000

Cash

28000

Goodwill

120000

O’Donnell Capital

120000

Reese Capital

120000

12/31/2016

Reese Capital

41000

O’Donnell Capital

32000

Income summary

9000

01/01/2017

Cash

10000

Goodwill

47750

Dunn Capital

57750

12/31/2017

O’Donnell Capital

22800

Reese Capital

11850

Dunn Capital

8663

O’Donnell drawings

22800

Reese drawings

11850

Dunn drawings

8663

12/31/2017

Income summary

85000

O’Donnell Capital

38900

Reese Capital

23050

Dunn Capital

23050

01/01/2018

Goodwill

17473

O’Donnell Capital

1747

Reese Capital

7663

Dunn Capital

7663

01/01/2018

Dunn Capital

60000

Postner Capital

60000

12/31/2018

O’Donnell Capital

25477

Reese Capital

14709

Postner Capital

12000

O’Donnell drawings

25477

Reese drawings

14709

Postner drawings

12000

12/31/2018

Income summary

65000

O’Donnell Capital

40469

Reese Capital

14709

Postner Capital

12000

01/01/2019

Goodwill

17838

O’Donnell Capital

1784

Reese Capital

8027

Postner Capital

8027

01/01/2019

Postner Capital

88293

Cash

88293

Explanation:

01/01/2016

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

13/31/2016

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.

01/01/2017

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 =

$38200

Goodwill =

$47750

12/31/2017

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.

12/31/2017

To allocate $85,000 income figure as follows:

O’Donnell

Reese

Dunn

Interest (20% of $152000
beginning capital balance)

30400

10% of $85000 income

8500

50:50 spilt of remaining $46100 income

23050

Total

$38900

$23050

Capital balances as of December 31, 2017:

O’Donnell

Reese

Dunn

Initial 2016 investment

$120000

2016 profit allocation

32000

(41000)

Additional investment

57750

2017 drawings

(22800)

(11850)

(8663)

2017 profit allocation

38900

23050

12/31/2017 balances

$168100

$90200

$72137

01/01/2018

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.

12/31/2018

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

12/31/2018

To allocate profit for 2018 as follows:

O’Donnell

Reese

Postner

Interest (20% of $169847
beginning capital balance)

33969

10% of $65000 income

6500

50:50 spilt of remaining $24531 income

12266

Total

$40469

$12266

Capital Balances as of December 31, 2018:

O’Donnell

Reese

Postner

12/31/2017 balances

$168100

$90200

$72137

Adjustment for Goodwill

1747

7863

Drawings

(25477)

(14709)

(12000)

Profit allocation

40469

12266

12/31/2018

$184139

$95620

$80266

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:

01/01/2019

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

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

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

To recognize implied goodwill.

1/1/2019

Postner's 12/31/2018 balance $80,266 × 110% = $88,293

To record final distribution to Postner.

Date

General journal

Debit

Credit

01/01/2016

Building

60000

Equipment

32000

Cash

28000

O’Donnell Capital

60000

Reese Capital

60000

12/31/2016

Reese Capital

29000

O’Donnell Capital

20000

Income summary

9000

01/01/2017

Cash

10000

O’Donnell Capital

1420

Reese Capital

12780

Dunn Capital

24200

12/31/2017

O’Donnell Capital

11787

Reese Capital

5000

Dunn Capital

5000

O’Donnell drawings

11787

Reese drawings

5000

Dunn drawings

5000

12/31/2017

Income summary

85000

O’Donnell Capital

24216

Reese Capital

30392

Dunn Capital

30392

01/01/2018

Dunn Capital

49592

Postner Capital

49592

12/31/2018

O’Donnell Capital

13651

Reese Capital

6542

Postner Capital

7439

O’Donnell drawings

13651

Reese drawings

6542

Postner drawings

7439

12/31/2018

Income summary

65000

O’Donnell Capital

24702

Reese Capital

20149

Postner Capital

20149

01/01/2019

O’Donnell Capital

62302

Dunn Capital

623

Reese Capital

5607

Cash

68532

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