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.

Answer 1

a.

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	30392
Total	$24216	$30392	$30392

Capital Balances as of December 31, 2017:

	O’Donnell	Reese	Dunn
Initial 2016 investment	$60000	$60000
2016 profit allocation	20000	(29000)
Dunn's investment	(1420)	(12780)	24200
2017 drawings	(11787)	(5000)	(5000)
2017 profit allocation	24216	30392	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	20149
Total	24702	20149	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.

b.

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	23050
Total	$38900	$23050	$23050

Capital balances as of December 31, 2017:

	O’Donnell	Reese	Dunn
Initial 2016 investment	$120000	$120000
2016 profit allocation	32000	(41000)
Additional investment			57750
2017 drawings	(22800)	(11850)	(8663)
2017 profit allocation	38900	23050	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	12266
Total	$40469	$12266	$12266

Capital Balances as of December 31, 2018:

	O’Donnell	Reese	Postner
12/31/2017 balances	$168100	$90200	$72137
Adjustment for Goodwill	1747	7863	7863
Drawings	(25477)	(14709)	(12000)
Profit allocation	40469	12266	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.