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 $104,000 and equipment valued at $44,000 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 20 percent of partnership income each year (without regard for the preceding interest figure) or $5,000, 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 $8,000 annually or 10 percent of the beginning capital balance for the year, whichever is larger.

The partnership reported a net loss of $8,000 during the first year of its operation. On January 1, 2017, Terri Dunn becomes a third partner in this business by contributing $40,000 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 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 $135,000 directly to Dunn. Net income for 2018 is $72,000 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.

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

Part A

Date	Account titles and explanation	debit	Credit
1/1/16	Building	104000
	Equipment	44000
	Cash	42000
	O'Donnell, Capital		95000
	Reese, Capital		95000
	(To record initial investment. Assets recorded at fair value with two equal capital balances.)
12/31/16	Reese, Capital	19500
	O'Donnell, Capital (95000*10%)+5000		14500
	Income Summary		5000
1/1/17	Cash	40000
	O'Donnell, Capital (20%)	3250
	Reese, Capital (80%)	13000
	Dunn, Capital		56250
12/31/17	O'Donnell, Capital (95000+14500-3250)*10%	10625
	Reese, Capital (95000-19500-13000)*10% or 8000 (whichever is greater)	8000
	Dunn, Capital (56250*10%) or 8000 (whichever is greater)	8000
	O'Donnell, Drawings		10625
	Reese, Drawings		8000
	Dunn, Drawings		8000
12/31/17	Income Summary	74000
	O'Donnell, Capital		25425
	Reese, Capital		29145
	Dunn, Capital		19430
1/1/18	Dunn, Capital	67680
	Postner, Capital		67680
12/31/18	O'Donnell, Capital (121050*10%)	12105
	Reese, Capital (83645*10%)	8365
	Postner, Capital (61865*10%)	8000
	O'Donnell, Drawings		12105
	Reese, Drawings		8365
	Postner, Drawings		8000
12/31/18	Income Summary	90000
	O'Donnell, Capital		48038
	Reese, Capital		25177
	Postner, Capital		16785
1/1/19	Postner, Capital (67680-8000+18198)	77878
	O'Donnell, Capital (20%)	1558
	Reese, Capital (80%)	6230
	Cash		85666

Part B

Date	Account titles and explanation	debit	Credit
1/1/16	Building	104000
	Equipment	44000
	Cash	42000
	Goodwill	190000
	O'Donnell, Capital		190000
	Reese, Capital		190000
12/31/16	Reese, Capital	32000
	O'Donnell, Capital		24000
	Income Summary (loss given)		8000
1/1/17	Cash	40000
	Goodwill	84000
	Dunn, Capital		124000
12/31/17	O'Donnell, Capital (190000+24000)*10%	21400
	Reese, Capital (190000-29000)*10%	16100
	Dunn, Capital (124000*10%)	12400
	O'Donnell, Drawings		21400
	Reese, Drawings		16100
	Dunn, Drawings		12400
12/31/17	Income Summary	74000
	O'Donnell, Capital		75800
	Reese, Capital		2520
	Dunn, Capital		1680
1/1/18	Goodwill (135000-126720)/32%	25875
	O’Donnell Capital (31529*20%)		5175
	Reese, Capital (31529*48%)		12420
	Postner, Capital (31529*32%)		8280
1/1/18	Dunn, Capital	135000
	Postner, Capital		135000
12/31/18	O'Donnell, Capital	23398
	Reese, Capital	18000
	Postner, Capital	13500
	O'Donnell, Drawings ((228800+5175)*10%)		23398
	Reese, Drawings ((167580+12420)*10%)		18000
	Postner, Drawings (135000*10%)		13500
12/31/18	Income Summary	72000
	O'Donnell, Capital		80646
	Reese, Capital		5612
	Postner, Capital		3742
1/1/19	Goodwill (13518/32%)	42244
	O'Donnell, Capital (20%)		8449
	Reese, Capital (48%)		20277
	Postner, Capital (32%)		13518
1/1/19	Postner, Capital	148699
	Cash (135181*110%)		148699

	O'Donnell	Reese	Dunn
Interest (10% of $106250 beginning capital balance)	10625
20% of $74000 income	14800
60:40 spilt of remaining $48575 (74000-10625-14800) Income		29145	19430
Total	25425	29145	19430

Capital Balances as of December 31, 2017:

	O'Donnell	Reese	Dunn
Initial 2016 investment	95000	95000
2016 profit allocation	14500	(19500)
Dunn's investment	(3250)	(13000)	56250
2017 drawings	(10625)	(8000)	(8000)
2017 profit allocation	25425	29145	19430
12/31/17 balances	121050	83645	67680

	O'Donnell	Reese	Postner
Interest (10% of $121050 beg. capital)	12105
20% of $72000 income	14400
60:40 split of remaining $45495 (72000-12105-14400)		27297	18198
Totals	26505	27297	18198

$40,000 + Goodwill = 25% (Current Capital + $40,000 + Goodwill)

$40,000 + Goodwill = 25% ($372000 + $40,000 + Goodwill)

$40,000 + Goodwill = $103000 + 0.25 Goodwill

0.75 Goodwill = $63000

Goodwill = $84000

	O'Donnell	Reese	Dunn
Interest (10% of $214,000 beginning capital balance)	21400
20% of $74,000 income	14800
60:40 spilt of remaining $37800 (74000-21400-14800) Income		22680	15120
Total	36200	22680	15120

Capital Balances as of December 31, 2017:

	O'Donnell	Reese	Dunn
Initial 2016 investment	190000	190000
2016 profit allocation	24000	(29000)
Additional investment			124000
2017 drawings	(21400)	(16100)	(12400)
2017 profit allocation	36200	22680	15120
12/31/17 balances	228800	167580	126720

In effect, profits are shared 20% to O'Donnell, 48 % to Reese – (60% of the 80% remaining after O'Donnell's income), and 32% to Dunn (40% of the 80% remaining after O'Donnell's income).