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 $62,000 and equipment valued at $36,000 as well as $32,000 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 20 percent of partnership income each year (without regard for the preceding interest figure) or $4,000, 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 $6,000 annually or 10 percent of the beginning capital balance for the year, whichever is larger.

The partnership reported a net loss of $10,000 during the first year of its operation. On January 1, 2020, Terri Dunn becomes a third partner in this business by contributing $25,000 cash to the partnership. Dunn receives a 25 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 6:4 basis between Reese and Dunn, respectively.

Partnership income for 2020 is reported as $62,000. 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 $95,000 directly to Dunn. Net income for 2021 is $66,000 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.

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

The total capital contribution of the firm:

Building	62000
Equipment	36000
Cash	32000
	130000
Journal Entry
Building a\c Dr.	62000
Equipment a\c Dr.	36000
Cash a\c Dr.	32000
To O' Donell capital		130000
Since in the year 2019, there was a loss hence 4000 will be credited to his partnership income, as it is higher.
Profit and loss a\c Dr.	4000
To O' Donell capital		4000
Interest on capital (p&l) a\c Dr.	13000
To O' Donell capital		13000
(for interest credited to his capital a\c)
Reese capital a\c Dr.	27000
To profit and loss a\c		27000
(loss allocated to Reese a\c)
No amount is credited to Reese a\c as there is a loss.
In the year 2020 Dunn is admitted with 25% partnership share
Bonus method
The total capital contribution is 147000 of partnership firm
Dunn brings 25000 cash
Total capital = 147000 + 25000 = 172000
Dunn's share = 172000*25% = 43000
The admission of a new partner for an amount less than book value results in the following journal entry.
Hence the Journal entry would be
Cash a\c Dr.	25000
Reese capital a\c Dr.	18000
To Dunn's capital a\c		43000
The whole loss is born by Reese as O' Donell is only entitled to fixed profit
In the year 2020 Dunn is admitted with 25% partnership share
Goodwill method
The total capital contribution is 147000 of partnership firm
Dunn brings 25000 cash
Implied partnership valuation = 147000/75% = 196000
Dunn's share = 196000-147000 = 49000
Godwill = 49000- 25000 = 24000
Hence the Journal entry would be
Cash a\c Dr.	25000
Goodwill a\c Dr.	24000
To Dunn's capital a\c		49000
For the year 2020, profit is 62000, the entries are as follows:
Interest on capital (p&l) a\c Dr.	13000
To O' Donell capital		13000
(for interest credited to his capital a\c)
Profit and loss a\c Dr.	9800
To O' Donell capital		9800
(profit for O' Donell = (62000-13000)*20% = 9800 or 4000 higher
The remaining profit i.e. (62000- 22800 = 39200) to be distributed to Reese and Dunn in the ratio of 6:4
Profit and loss a\c Dr.	39200
To Reese's capital a\c		23520
To Dunn's capital a\c		15680
(profit distribution between partners)
Dunn sells her interest to Postner and Postner pays directly to Dunn
Dunn's share
If bonus method is followed
Initial capital	43000
+ profit for the year	15680
- withdrawal during the year	6000
Balance at end	52680
She sold her share at a profit of 95000-52680 =42320
Dunn sells her interest to Postner and Postner pays directly to Dunn
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