Question

In: Accounting

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

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 $100,000 and equipment valued at $88,000 as well as $42,000 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 15 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 2016. Thereafter, each can draw $9,000 annually or 20 percent of the beginning capital balance for the year, whichever is larger.

The partnership reported a net loss of $12,000 during the first year of its operation. On January 1, 2017, Terri Dunn becomes a third partner in this business by contributing $32,000 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 6:4 basis between Reese and Dunn, respectively.

Partnership income for 2017 is reported as $74,000. 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 $120,000 directly to Dunn. Net income for 2018 is $76,000 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.

Solutions

Expert Solution

Bonus method

DATE	PARTICULARS		DEBIT ($)	CREDIT ($)
January 1,2016	Building A/c Equipment A/c Cash A/c To Rob O’Donnell’s Capital A/c (being entry to record investment in firm)	Dr. Dr. Dr.	100,000 88,000 42,000	230,000
December 31,2016	Interest on Capital A/c To Rob O’Donnell’s Capital A/c (being entry to record interest on capital 230,000 * 10%)	Dr.	23,000	23,000
December 31,2016	Profit and Loss A/c To Rob O’Donnell’s Capital A/c (being balance transferred from Profit and loss A/c as per agreement)	Dr.	4,000	4,000
January 1, 2017	Cash A/c Steve Resse’s Capital A/c Rob O’Donnell’s Capital A/c To Terri Dunn’s Capital A/c (being entry for admission of partner under bonus method)	Dr. Dr. Dr.	32,000 15,300 2,700	50,000
December 31, 2017	Interest on Capital A/c To Rob O’Donnell’s Capital A/c (being entry to record interest on capital 257,000 * 10%)	Dr.	25,700	25,700
December 31, 2017	Profit and loss A/c To Steve Resse’s Capital A/c To Rob O’Donnell’s Capital A/c To Terri Dunn’s Capital A/c (being entry for transfer of profit to capital accounts)	Dr.	74,000	37,740 11,100 25,160
January 1,2018	Terri Dunn’s Capital A/c To Postner’s Capital A/c (being entry for transfer of share of capital)	Dr.	84,160	84,160
December 31,2018	Interest on Capital A/c To Rob O’Donnell’s Capital A/c (being entry to record interest on capital 239.700 * 10%)	Dr.	23970	23970
December 31,2018	Profit and Loss A/c To To Steve Resse’s Capital A/c To Rob O’Donnell’s Capital A/c To Postner’s Capital A/c (Being entry for transfer of profit)	Dr.	76,000	38,760 11,400 25,840
January 1,2019	Postner’s capital A/c To Cash A/c (being entry for withdrawl of partnership by Postner)	Dr.	86,644.80	86,644.80

(Note: it is assumed that profit is allocated before payment of interest on capital to Rob O’Donnell)

Workings:

1) Capital balance of Rob O’Donnell at the end of year 2016

230,000 + 23,000 + 4,000 = $ 257,000

Total Capital of firm = Opening capital of the Rob O’Donnell – Loss incurred

= 230,000 – 12000 = $ 218,000

2) Capital contributed by Terri Dunn = $ 32,000

Total capital of firm after contribution by Terri Dunn = $ 32,000 + $ 218,000 = $ 250,000

Share of Dunn = 20%

So, the Capital of Dunn will be 250,000 * 20% = $ 50,000

So, Bonus = $ 32,000 - $ 50,000 = - $ 18,000

This bonus will be allocated among existing partners as follows:

Steve Reese = -18,000 x 85% = - $ 15,300

Rob O’Donnell = -18,000 x 15% = - $ 2,700

3) New profit and loss ratio

Profit share of Rob O’Donnell = 15%

Profit Share of Steve Reese = 85% x 6 / 10 = 51%

Profit Share of Terri Dunn = 85% x 4 / 10 = 34%

4) The transfer of share from Dunn to Postner will not have any effect in the books of accounts except for change in the name of capital account.

5) Balance of capital account

Particulars	Steve Reese	Rob O’Donnell	Terri Dunn / Postner
Opening balance for year 2016	0	2,30,000	0
Interest + Profit	-27,000	27,000	0
Closing balance for year 2016	-27000	257000	0

Opening balance for year 2017	-27000	2,57,000	0
Capital addition	0	0	32,000
Goodwill allocation	-15,300	-2,700	18,000
Interest + profit	37,740	36,800	25,160
Drawings	-9,000	-51,400	-9,000
Closing balance for year 2017	-13,560	2,39,700	66,160

Opening balance for year 2018	-13,560	2,39,700	66,160
Interest + profit	38,760	35,370	25,840
Drawings	-9,000	-47,940	-13,232
Closing Balance for year 2018	16,200	2,27,130	78,768

6) Drawings for year 2017

Particulars	Steve Reese	Rob O’Donnell	Terri Dunn / Postner
a. 20% of opening balance	0	51,400	0
b. Other option	9,000	9,000	9,000
Higher of (a) and (b)	9,000	51,400	9,000

7) Drawings for year 2018

Particulars	Steve Reese	Rob O’Donnell	Terri Dunn / Postner
a. 20% of opening balance	0	47,940	13,232
b. Other option	9,000	9,000	9,000
Higher of (a) and (b)	9,000	47,940	13,232

8) Balance that can be withdrawn by Postner = 78,768 + 10% of 78,768 = 78,768 + 7,876.8

= $ 86,644.8

Goodwill Method

Goodwill method

DATE	PARTICULARS		DEBIT ($)	CREDIT ($)
January 1,2016	Building A/c Equipment A/c Cash A/c To Rob O’Donnell’s Capital A/c (being entry to record investment in firm)	Dr. Dr. Dr.	100,000 88,000 42,000	230,000
December 31,2016	Interest on Capital A/c To Rob O’Donnell’s Capital A/c (being entry to record interest on capital 230,000 * 10%)	Dr.	23,000	23,000
December 31,2016	Profit and Loss A/c To Rob O’Donnell’s Capital A/c (being balance transferred from Profit and loss A/c as per agreement)	Dr.	4,000	4,000
January 1, 2017	Cash A/c Steve Resse’s Capital A/c Rob O’Donnell’s Capital A/c To Terri Dunn’s Capital A/c (being entry for admission of partner under bonus method)	Dr. Dr. Dr.	32,000 49,300 8,700	90,000
December 31, 2017	Interest on Capital A/c To Rob O’Donnell’s Capital A/c (being entry to record interest on capital 257,000 * 10%)	Dr.	25,700	25,700
December 31, 2017	Profit and loss A/c To Steve Resse’s Capital A/c To Rob O’Donnell’s Capital A/c To Terri Dunn’s Capital A/c (being entry for transfer of profit to capital accounts)	Dr.	74,000	37,740 11,100 25,160
January 1,2018	Terri Dunn’s Capital A/c To Postner’s Capital A/c (being entry for transfer of share of capital)	Dr.	106160	106160
December 31,2018	Interest on Capital A/c To Rob O’Donnell’s Capital A/c (being entry to record interest on capital 233,700 * 10%)	Dr.	23,370	23,370
December 31,2018	Profit and Loss A/c To To Steve Resse’s Capital A/c To Rob O’Donnell’s Capital A/c To Postner’s Capital A/c (Being entry for transfer of profit)	Dr.	76,000	38,760 11,400 25,840
January 1,2019	Postner’s capital A/c To Cash A/c (being entry for withdrawl of partnership by Postner)	Dr.	121,844.8	121,844.8