Question

When two or more individuals come together to form a partnership, the assets that they bring with them into the partnership may be disproportionate. In this event, the assignment of capital may be based on the bonus method or the goodwill method. Please compare and contrast these methodologies in the formation of a partnership. Feel free to use examples.

Answer 1

Bonus Accounting Method: While admitting a new partner, his/her capital contribution that may not be equal to the share of the book value of the capital interest that is purchased.

If such capital contribution is higher than the book value of the capital interest, then the difference, which is referred to as a bonus, will be distributed among the old partners.

However, if the capital contribution is lower than the book value of the capital interest that has been purchased, then the bonus will be allocated to that new partner.

Example:

A and B are partners who share profits and losses on a 7:3 respectively. The capital balance of A is $ 20, 000 and B is $ 10,000. The decision has been made to admit C as a third partner upon payment to the business of cash of $ 15,000 for a 30% ownership in the business.

As per the bonus approach, total capital after an admission of a new partner is simply the prior capital plus or minus any change in net assets.

So, the capital is $ 30,000 and C added in cash of $ 15,000. Therefore, Total capital has increased to $ 45,000. The payment to the business of $ 10,000 increases total capital to $ 45,000. C is entitled to 30% of this new business so his beginning capital balance is recorded as $ 13,500 ($ 45,000 * 30%). In the bonus method, total capital is determined after the addition or subtraction of assets and liabilities. The new partner is then assigned the appropriate percentage of that total.

Goodwill Accounting Method:

Sometimes, when admitting a new partner, his/her capital contribution that may not be equal to the share of the book value of the capital interest that is purchased. In such a case, that differences (in both the cases ie excess or lesser) will be recorded as an intangible asset called Goodwill.

This method deals in two situations: -

1. The capital contribution is higher than the percentage of the book value of partnership purchased.
2. The capital contribution is lower than the percentage of the book value of partnership purchased.

Example:

A and B have capital balances of $ 30,000 and $ 25,000. They admit C into the business. C pays $ 30,000 to the business in order to acquire a 30% ownership.

As per the goodwill approach,

C is paying $ 30,000 for a 30% ownership share indicates an implied worth for the entire business of $ 100,000 (ie $ 30,000*100/30). Without adjustment, total capital would be $ 85,000 (ie 30,000+25000+30000). Hence, difference $ 15,000 must be recognized as Goodwill to increase the capital from $ 85,000 to the implied value of $ 100,000.