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, 2019, 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 2019. 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, 2020, 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 2020 is reported as $94,000. Each partner withdraws the full amount that is allowed.

On January 1, 2021, 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 2021 is $94,000 with the partners again taking their full drawing allowance.

On January 1, 2022, 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 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.

1	01/01/2019	Building
		Equipment
		Cash
		Goodwill
		O'Donnell, capital
		Reese, capital
2	12/31/2019	Reese, capital
		O'Donnell, capital
		Income summary
3	01/01/2020	Cash
		Goodwill
		Dunn, capital
4	12/31/2020	O'Donnell, capital
		Reese, capital
		Dunn, capital
		O'Donnell, drawings
		Reese, drawings
		Dunn, drawings
5	12/31/2020	Income summary
		O'Donnell, capital
		Reese, capital
		Dunn, capital
6	01/01/2021	Goodwill
		O'Donnell, capital
		Reese, capital
		Dunn, capital
7	01/01/2021	Dunn, capital
		Postner, capital
8	12/31/2021	O'Donnell, capital
		Reese, capital
		Postner, capital
		O'Donnell, drawings
		Reese, drawings
		Postner, drawings
9	12/31/2021	Income summary
		O'Donnell, capital
		Reese, capital
		Postner, capital
10	01/01/2022	Goodwill
		O'Donnell, capital
		Reese, capital
		Postner, capital
11	01/01/2022	Postner, capital
		Cash

Answer 1

1	Journal entries to record the transactions on the assumption that the goodwill
	(or revaluation) method is used.
Date	Account Titles and description	Debit	Credit
1-Jan-19	Building	$124,000
	Equipment	$128,000
	Cash	$48,000
	Goodwill	$300,000
	O'Donnell Capital		$300,000
	Reesee, Capital		$300,000
	(To record initial investment of assets by partners)
31-Dec-19	Reese Capital	$77,000
	O'Donnell Capital		$66,000	(300,000*20%+6000)
	Income Summary		$11,000
	(To record redistribution of net income to partners)
1/1/2020	Cash	$19,000
	Goodwill	$131000
	Dunn Capital		$150,000
	(to record admittance of Dunn into the partnership)
	Calculation of goodwill
	$19000+Goodwill = 20% (Current capital+Dunn Capital)
	$19000+Goodwill = 20% (600000+19000+Goodwill)
	$19000+Goodwill = $123800+0.20Goodwill
	0.80 Goodwill = $123800-$19000
	Goodwill = 104800/0.80 = 131000
12/31/2020	O'Donnell Capital	$54,900
	Reese Capital	$33,450
	Dunn Capital	$22,500
	O'Donnell Drawing		$54,900	(300000+66000)*15%
	Reese Drawing		$33,450	(300000-77000)*15%
	Dunn Drawing		$22,500	(150000*15%)
	(To close drawing accounts)
12/31/2020	Income Summary	$94,000
	O'Donnell Capital		$82,600	(366000*20%)+(94000*10%)
	Reese Capital		$5,700	(94000-82600)*50%
	Dunn Capital		$5,700	(94000-82600)*50%
	(to record distribution of net income to partners)
1/1/2021	Goodwill	$29,500
	O'Donnell Capital		$5,900	(29500*20%)
	Reese Capital		$11,800	(29500*40%)
	Dunn Capital		$11,800	(29500*40%)
	(To record goodwill indicated by purchase of Dunn's interest)
	Closing capital balance on 31/12/2020
		O'Donnell	Reese	Dunn
	Initial Investment	$300,000	$300,000
	2019 profit allocation	$66,000	($77,000)
	Additional investment			$150,000
	2020 drawings	($54,900)	($33,450)	($22,500)
	2020 profit allocation	$82,600	$5,700	$5,700
	12/31/2020 Capital balance	$393,700	$195,250	$133,200
	Judy paid $145,000 for Dunn's share. Thus she paid $11800 (145,000-133,200) in excess of Dunn's share.
	This $11800 is for 40% share of Dunn (20% of remaining 80% interest after Donnell share)
	Total goodwill will be 11800/40% = 29500
1/1/2021	Dunn's Capital	$145,000
	Posnter Capital		$145,000
	(To record admittance of Postner into the partnership)
12/31/2021	O'Donnell Capital	$59,940
	Reese Capital	$31,058
	Postner Capital	$21,750
	O'Donnell Drawing		$59,940	(393,700+5,900)*15%
	Reese Drawing		$31,058	(195,250+11,800)*15%
	Postner Drawing		$21,750	(145,000*15%)
	(To close drawing accounts)
12/31/2021	Income Summary	$94,000
	O'Donnell Capital		$88,140	(393,700*20%)+(94000*10%)
	Reese Capital		$2,930	(94000-88140)*50%
	Postner Capital		$2,930	(94000-88140)*50%
	(to record distribution of net income to partners)
1/1/2022	Goodwill	$83,300
	O'Donnell Capital		$16,660	(83300*20%)
	Reese Capital		$33,320	(83300*40%)
	Postner Capital		$33,320	(83300*40%)
	(To record goodwill indicated by withdrawal of Postner interest)
	Closing capital balance on 31/12/2021
		O'Donnell	Reese	Dunn
	12/31/2020 Capital balance	$393,700	$195,250	$133,200
	Adjustment for Goodwill	$5,900	$11,800	11,800
	2021 drawings	($59,940)	($31,058)	($21,750)
	2021 profit allocation	$88,140	$2,930	$2,930
	12/31/2021 Capital balance	$427,800	$178,922	$126,180
	Postner will be paid $159500 (145000+14500) for her interest. This amount exceed $33320 from her capital
	balance. As Postner is entitled to 40% of interest in partnership, this excess will give rise to $83300 (33320/40%)
	amount of goodwill
1/1/2022	Postner Capital	$159,500
	Cash		$159,500
	(To record final distribution to Postner)

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