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CHAPTER 9
PARTNERSHIPS: FORMATION AND OPERATION
Chapter Outline
I. Business organizations that are formed legally as partnerships, although they are not always
as visible as corporations, still proliferate throughout this country especially in the legal,
medical, and accounting professions.
A. Advantages of the partnership format include ease of creation and the absence of the
double taxation effect inherent to the income earned by a corporation and distributed to
its owners.
B. Partnerships, however, rarely grow to a significant size (when compared with large
corporate organizations) primarily because of the unlimited liability being assumed by
each general partner.
C. Alternative legal formats have been created over the years to combine the benefits of
corporations and partnerships such as S corporations, limited liability partnerships, and
limited liability companies.
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Chapter 09 - Partnerships: Formation and Operation
1. The partners can simply assume an equal division of profits and losses.
2. The partners, however, can select any method that is designed to arrive at an
equitable allocation. Such factors as the amounts of capital invested, the time
worked in the business, and the degree of business expertise may all serve to
influence the assignment of income.
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Chapter 09 - Partnerships: Formation and Operation
The owners of this business face a common problem: they began operations without seriously
considering the companys legal form. The accountant now needs to specify the advantages
and disadvantages of the partnership versus corporate or some other legal form. Eventually, the
owners must make this decision but should consider all relevant factors in their choice.
The accountant should discuss the following issues with the two owners:
Business liabilities. In a partnership, any partner may be held liable for all business debts.
Thus, if liabilities escalate and the business fails, each partner risks a large possible loss.
The same problem does not exist in a corporation where owners and the business are
separate entities. For the owners, potential losses are, in corporations, normally limited to the
amount being invested. However, in many small, newly created, corporations, the owners are
required to personally guarantee any loans. Therefore, to an extent, the concept of unlimited
liability may actually be present in either case. The partners should forecast the amount of
debts that will be incurred and the possible outcome if the business would happen to fail.
Lawsuits. Some businesses are more susceptible to lawsuits than others. A florist, for
example, would likely have less risk than a pharmaceutical company. The concept of
personal liability for business debts becomes especially important when litigation risk is high.
To reduce such risk, creating a corporation to protect the personal property of the
stockholders may be a wise move. The owners of a partnership may become personally
responsible for losses created by a business mistake or accident. The need for this
responsibility is recognized in states that prohibit doctors, lawyers, accountants, and the like
from incorporating. Such states, however, allow licensed professionals to operate LLPs.
Taxation. In a partnership, all income is allocated to the owners immediately and they are
taxed on this amount. Double-taxation is avoided. A corporation pays an income tax and any
dividends are then taxed again when collected by the owners. Therefore, traditionally,
partnerships are viewed as having a tax advantage. The accountant should also mention to
the partners other possible tax factors that may affect their decision. For example, in small
corporations, double taxation may not be a problem. If salaries paid to the owners are
reasonable and approximate the company's profits so that no dividends are distributed, only
one tax is paid in either case. As another issue, if a partnership suffers a loss (which often
happens when companies begin operations), that loss is passed to the partners and can be
used to reduce other taxable income. However, in a corporation, losses are carried back and
forward to reduce other taxable income that is earned by the business, possibly delaying the
benefits of the loss. As mentioned in the textbook, the owners should consider forming an S
Corporationa business that is incorporated but still taxed as a partnership.
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Chapter 09 - Partnerships: Formation and Operation
Bankruptcy. If the business should ever fail and have to be liquidated, losses of a partnership
are passed directly to the owners to reduce taxable income immediately. For a corporation,
the loss is a capital loss to the stockholders which can only offset their own capital gains or
be deducted at the rate of $3,000 per year. Thus, if a large loss is incurred, the tax benefits
may not be realized for years into the future.
Growth potential. Traditionally, corporations have more growth potential than do partnerships.
Ownership interests can be easily transferred. The limitation on liability encourages
ownership by individuals who cannot participate in the management of the company.
Partnerships are more restricted in adding new owners. Partnerships usually have to entice
individuals who are willing to work in the business in order to obtain additional capital.
Therefore, the accountant may want to address the following questions in advising these
clients:
What amount of time and energy is involved in becoming incorporated?
How much profit or loss is anticipated from the operations of this business in the
foreseeable future?
How much debt will the new business incur?
Will this debt be guaranteed by the owners?
How much salary do the owners anticipate withdrawing from the business?
What are the chances of incurring lawsuits?
What is the possibility that the business will fail?
How large do the owners expect this business to grow? Do they anticipate the need
for new owners and new capital?
Does the creation of an S Corporation apply to this particular business?
This case is designed to point up the difficulty of designing a profit-sharing arrangement that is
fair to all parties. Currently, these three individuals have incomes totaling an amount in excess
of the first year income that is expected. Thus, the adopted plan will have an immediate impact
on them. The reduction of income must be absorbed by the partners in some equitable manner.
In addition, the income is projected to increase relatively fast so that the agreed-upon method
needs to reward all participants properly over time.
Dewars has built up the firm and still handles the bigger clients although he plans to reduce his
workload over the next few years. Thus, one method of compensation would be to credit him
with interest on the capital built up in the business. However, if that number alone is used, it will
tend to escalate even if his work hours are reduced. For this reason, Dewars' share of the
profits could also be based in some way on the number of hours that he works. According to the
information presented, this number will probably shrink over the years, reducing the profits
allocated to Dewars. Thus, this partner might be given interest equal to 10 percent of his capital
balance and $50 for each hour worked.
Huffman is contributing a significant number of hours to the firm but tends to work on the smaller
jobs. A possible allocation technique would be to give this partner a per hour allocation but one
that is somewhat smaller than Dewars. For example, Huffman could receive an income
allocation of $30 per hour to begin. That number could then be programmed to escalate over
the years as Huffman starts to take over the bigger jobs.
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Chapter 09 - Partnerships: Formation and Operation
Scriba's role is to develop a tax practice within the firm. Consequently, one suggestion would be
to credit her capital account with a percentage of the tax revenues (20 percent, for example)
each year. In that way, she benefits by the amount of business that she is able to bring to the
organization. During the first years, though, she may have trouble getting the new part of this
business to generate significant revenues. Thus, the partners may want to set a minimum figure
for her income allocation. She could be credited, as an example, with 20 percent of tax
revenues but not less than $50,000.
Many answers to this question are possible. The above is just a simple suggestion based on the
facts presented in the case. Income allocation techniques are usually designed to reward the
partners for the attributes that they bring to the organization. Even with the above system,
percentages would still be necessary to assign any remaining profit or loss. If the partners are
not totally satisfied with the system as designed, the percentages could be weighted or adjusted
to reward any partner not being properly compensated.
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Chapter 09 - Partnerships: Formation and Operation
Answers to Questions
1. The advantages of operating a business as a partnership include the ease of formation and
the avoidance of the double taxation effect that inherently reduces the profits distributed to
the owners of a corporation. In addition, because the losses of a partnership pass, for tax
purposes, directly through to the owners, partnerships have historically been used
(especially in certain industries) to reduce or defer income taxes.
Several disadvantages also accrue from the partnership format. Each general partner, for
example, has unlimited liability for all debts of the business. This potential liability can be
especially significant in light of the concept of mutual agency, the right that each partner has
to create liabilities in the name of the partnership. Because of the risks created by unlimited
liability and mutual agency, the growth potential of most partnerships is severely limited. Few
people are willing to become general partners in an organization unless they can maintain
some day-to-day contact and control over the business.
Further discussion of these issues can be found in the Answer to the first Discussion
Question that appears above.
2. Specific partnership accounting problems center in the equity (or capital) section of the
balance sheet. In a corporation, stockholders' equity is divided between earned capital and
contributed capital. Conversely, for a partnership, each partner has an individual capital
account that is not differentiated according to its sources. Virtually all accounting issues
encountered purely in connection with the partnership format are related to recording and
maintaining these capital balances.
3. The balance in each partner's capital account measures that partner's interest in the book
value of the business net assets. This figure arises from contributions, earnings, drawings,
and other capital transactions.
5. In a general partnership, each partner can have unlimited liability for the debts of the
business. Therefore, a partner may face a significant risk, especially in connection with the
actions and activities of other partners. However, general partnerships are easy to form and
often serve well in smaller businesses where all partners know each other. The major
advantage of a general partnership is that all income earned by the business is only taxed
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Chapter 09 - Partnerships: Formation and Operation
once when earned by the business so that no second tax is incurred when distributions are
made to owners.
A limited liability partnership (LLP) is very similar to a general partnership except in the
method by which a partners liability is measured. In an LLP, the partners can still lose their
entire investment and be held responsible for all contractual debts of the business such as
loans. However, partners cannot be held responsible for damages caused by other partners.
For example, if one partner carelessly causes damage and is sued, the other partners are
not held responsible.
A limited liability company can now be created in certain situations. This type of organization
is classified as a partnership for tax purposes so that the double-taxation effect is avoided.
However, the liability of the owners is limited to their individual investments like a
Subchapter C Corporation. Depending on state law, the number of owners is not restricted
in the same manner as a Subchapter S Corporation so that there is a greater potential for
growth.
6. The Articles of Partnership is a legal agreement that should be created as a prerequisite for
the formation of a partnership. This document defines the rights and responsibilities of the
partners in relation to the business and in relation to each other. Thus, it serves as a
governing document for the partnership. The Articles of Partnership may contain any
number of provisions but should normally specify each of the following:
7. To give fair recognition to noncash contributions, all assets donated by the partners (such as
land or inventory) should be recorded by the partnership at their fair values at the date of
investment. However, for taxation purposes, the partners book value is retained.
8. In forming a partnership, one or more of the partners may be contributing some factor (such
as an established clientele or an expertise) which is not viewed normally as an asset in the
traditional accounting sense. In effect, the partner will be receiving a larger capital balance
than the identifiable contributions would warrant.
The bonus method of recording this transaction is to value and record only the identifiable
assets such as land and buildings. The capital accounts are then aligned to recognize the
proportionate interest being assigned to each partner's investment. If, for example, the
capital balances are to be equal, they are set at identical amounts that correspond in total to
the value of the identifiable assets.
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Chapter 09 - Partnerships: Formation and Operation
As an alternative, the amounts contributed along with the established capital percentages
can be used to determine mathematically the implied total value of the business and the
presence of any goodwill brought into the business. This goodwill is recognized at the time
that the partnership is created so that the amount can be credited to the appropriate partner.
9. The Drawing account measures the amount of assets that a particular partner takes from
the business during the current period. Often, only regularly allowed distributions are
recorded in the Drawing account with larger, more sporadic withdrawals being recorded as
direct reductions to the partner's capital balance.
10. At the end of each fiscal year, when revenues and expenses are closed out, some
assignment must be made of the resulting income figure Because a partnership will have
two or more capital accounts rather than a single retained earnings balance. This allocation
to the capital accounts is based on the agreement established by the partners preferably as
a part of the Articles of Partnership.
11. The allocation process can be based on any number of factors. The actual assignment of
income should be designed to give fair and equitable treatment to each of the partners.
Often, an interest factor is used to reward the capital investment of the partners. A salary
allowance is utilized as a means of recognizing the amount of time worked by an individual
or a certain degree of business expertise. The allocation process can be further refined by a
ratio that is either divided evenly among the partners or weighted in favor of one or more
members.
12. If agreement as to the allocation of income has not been specified, an equal division among
all partners is presumed. If an agreement has been reached for assigning profits but no
mention is made concerning losses, the assumption is made that the same method is
intended in either case.
13. The dissolution of a partnership is the breakup or cessation of the partnership. Many
reasons can exist for a partnership to dissolve. One partner may withdraw, retire, or die. A
new partner may be admitted to the partnership. The original partnership terminates
whenever the identity of the individuals serving as partners has changed.
Dissolution, however, does not necessarily lead to the liquidation of the business. In most
cases, but not all, a new partnership is formed which takes over the business. Such
dissolutions are no more than changes in the composition of the ownership and should not
affect operations.
14. A new partner can join a partnership by acquiring part or all of the interest of one or more of
the present partners. This transaction is carried out with the individual partners directly and
not with the partnership. A new partner may also enter through a contribution to the
business. In such cases, the investment is made to the partnership rather than to the
individuals.
15. In selling an interest in a partnership, three rights are conveyed to the new owner:
No problem exists in selling or assigning the first two of these rights. However, the right to
participate in management decisions can only be transferred with the consent of all partners.
16. Goodwill recognized in a capital transaction is allocated to the original partners based on the
profit and loss ratio. The amount is assumed to represent unrealized gains in the value of
the business. To determine the amount of goodwill, the implied value of the business as a
whole must be calculated based on the price being paid for a portion by the new partner.
The difference between this implied value and the total capital is assumed to be goodwill or
some other adjustment to asset value.
17. Allocating goodwill to an entering partner may be necessary for several reasons. One of the
most common is that the partner is bringing to the partnership an attribute that is not an
asset in the traditional accounting sense. For example, a new partner with an excellent
business reputation might be credited with goodwill at the time of entrance. Other factors
such as an established clientele or a professional expertise can justify attributing goodwill to
the new partner. The partnership might make this same concession to an entering partner if
cash is urgently needed by the business and a larger share of the capital has to be offered
as an enticement to generate the new investment.
18. Book values in most cases measure historical cost expenditures which often have
undergone years of allocation and changes in value. For this reason, book value will
frequently fail to mirror or even resemble the actual worth of a business. In addition, the
goodwill that is assumed to be present in a business as a going concern is not a factor that
is always reflected within book values. Therefore, distributing partnership property to a
withdrawing partner based on book value would not necessarily be fair. Hence, the Articles
of Partnership should spell out a method by which an equitable settlement can be achieved.
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Chapter 09 - Partnerships: Formation and Operation
Answers to Problems
1. B
2. C
3. D
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Chapter 09 - Partnerships: Formation and Operation
STATEMENT OF CAPITAL
ALFRED BERNARD COLLINS TOTAL
Beginning capital .................... $50,000 $60,000 $70,000 $180,000
Net income (above) ................. 12,400 30,900 16,700 60,000
Drawings (given) ..................... (5,000) (5,000) (5,000) (15,000)
Ending capital ......................... $57,400 $85,900 $81,700 $225,000
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Chapter 09 - Partnerships: Formation and Operation
11. (continued)
12. A Costello receives a $10,000 bonus ($100,000 less $90,000 capital balance).
This bonus is deducted from the two remaining partners according to their
profit and loss ratio (2:3). A 60 percent (3/5) reduction is assigned to Burns
which decreases that partners capital balance from $30,000 to $24,000.
Goodwill 50,000
Manning, capital (30%) 15,000
Gonzalez, capital (30%) 15,000
Clark, capital (20%) 10,000
Freeney, capital (20%) 10,000
14. B Under the bonus method, Clarks excess payment is deducted from the
remaining partners capital accounts according to their relative profit and loss
ratios, 3:3:2. Mannings balance is then $126,250 = $130,000 $3,750.
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Chapter 09 - Partnerships: Formation and Operation
15. A The implied value of the company is $900,000 ($270,000 30%). Because
the money is going to the partners rather than into the business, the capital
total is $490,000 before realigning the balances. Hence, goodwill of
$410,000 is recognized based on the implied value ($900,000 $490,000).
This goodwill is assumed to represent unrealized business gains and is
attributed to the original partners according to their profit and loss ratio.
They will then each convey 30 percent ownership of the $900,000
partnership to Darrow for a capital balance of $270,000.
16. D Because the money goes into the business, total capital becomes $740,000
($490,000 + $250,000). Darrow is allotted 30 percent of this total or
$222,000. Because Darrow invested $250,000, the extra $28,000 is assumed
to be a bonus to the original partners. Jennings will be assigned 40 percent
of this extra amount or $11,200. This bonus increases Jennings capital
from $160,000 to $171,200.
17. (10 Minutes) (Compute capital balances under both goodwill and bonus
methods)
a. Goodwill Method
Implied value of partnership ($80,000 40%) ............... $200,000
Total capital after investment ($70,000 + $40,000 + $80,000) 190,000
Goodwill ............................................................................ $ 10,000
Goodwill to Hamlet (7/10) ................................................ $ 7,000
Goodwill to MacBeth (3/10) ............................................. $ 3,000
Hamlet, capital (original balance plus goodwill) .......... $ 77,000
MacBeth, capital (original balance plus goodwill) ....... $ 43,000
Lear, capital (payment) (40% of total capital) ............... $ 80,000
b. Bonus Method
Total capital after investment ($70,000 + 40,000 + $80,000) $190,000
Ownership portionLear ................................................ 40%
Lear, capital ...................................................................... $ 76,000
Bonus payment made by Lear ($80,000 $76,000)....... $ 4,000
Bonus to Hamlet (7/10) .................................................... $ 2,800
Bonus to MacBeth (3/10) ................................................. $ 1,200
Hamlet, capital (original balance plus bonus) .............. $ 72,800
MacBeth, capital (original balance plus bonus) ........... $ 41,200
Lear, capital (40% of total capital) .................................. $ 76,000
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Chapter 09 - Partnerships: Formation and Operation
18. (15 Minutes) (Prepare journal entries to record admission of new partner under
both the goodwill and the bonus methods)
Part a.
Total capital is $300,000 ($85,000 + $60,000 + $55,000 + $100,000) after the
new investment. As Sergio's portion is 25 percent, this partner's capital
balance would be $75,000. Because $100,000 was paid, a bonus of $25,000
is given to the three original partners based on their profit and loss ratio:
Tiger$12,500 (50%), Phil$7,500 (30%), and Ernie$5,000 (20%).
Part b.
Total capital is $260,000 ($85,000 + $60,000 + $55,000 + $60,000) after the
new investment. As Sergio's portion is 25 percent, this partner's capital
balance is $65,000. Because only $60,000 was paid, a bonus of $5,000 is
taken from the three original partners based on their profit and loss ratio:
Tiger$2,500 (50%), Phil$1,500 (30%), and Ernie$1,000 (20%).
Part c.
Total capital is $272,000 ($85,000 + $60,000 + $55,000 + $72,000) after the
new investment. However, the implied value of the business based on the
new investment is $288,000 ($72,000 25%). Consequently, goodwill of
$16,000 must be recognized with the offsetting allocation to the original
partners based on their profit and loss ratio: Tiger$8,000 (50%), Phil
$4,800 (30%), and Ernie$3,200 (20%).
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Chapter 09 - Partnerships: Formation and Operation
19. (16 Minutes) (Determine capital balances after admission of new partner using
both goodwill and bonus methods)
Part a.
Total capital is $490,000 ($200,000 + $120,000 + $90,000 + $80,000) after the
new investment. However, the implied value of the business based on the
new investment is only $444,444 ($80,000 18%). According to the goodwill
method, this situation indicates that the new partner must be bringing
some intangible attribute to the partnership other than just cash. This
contribution must be computed algebraically and is recorded as goodwill
to the new partner.
CAPITAL BALANCES:
Nixon ...................................................................... $200,000
Hoover .................................................................... 120,000
Polk ...................................................................... 90,000
Grant ...................................................................... 90,000
Part b.
Total capital is $510,000 ($200,000 + $120,000 + $90,000 + $100,000) after
the new investment. As Grant's portion is to be 20 percent, this partner's
capital balance will be $102,000. Because only $100,000 was paid, a bonus
of $2,000 is taken from the three original partners based on their profit and
loss ratio: Nixon$1,000 (50%), Hoover$400 (20%), and Polk$600
(30%).
CAPITAL BALANCES
Original Investment Bonus Total
Nixon ..................... $200,000 $(1,000) $199,000
Hoover ................... 120,000 (400) 119,600
Polk ........................ 90,000 (600) 89,400
Grant ...................... -0- 100,000 2,000 102,000
Total ................. $510,000
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Chapter 09 - Partnerships: Formation and Operation
20. (10 Minutes) (Record admission of new partner and allocation of new income)
Part a.
Goodwill.................................................................. 18,000
Prince, capital .................................................. 14,400
Robbins, capital ............................................... 3,600
Cash ...................................................................... 37,000
Jeffrey, capital .................................................. 37,000
Part b.
Prince Robbins Jeffrey Total
Interest .................................. $8,440 $6,360 $3,700 $18,500
Remaining loss...................... (1,750) (1,050) (700) (3,500)
Income allocation ........... $6,690 $5,310 $3,000 $15,000
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Chapter 09 - Partnerships: Formation and Operation
ALLOCATION OF INCOME
Purkerson Smith Traynor Totals
Interest (10%) $ 6,600 (below) $ 4,000 $ 2,000 $12,600
Salary 18,000 25,000 8,000 51,000
Remaining income (loss):
$ 23,600
(12,600)
(51,000)
$(40,000) (16,000) (8,000) (16,000) (40,000)
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Chapter 09 - Partnerships: Formation and Operation
23. (30 Minutes) (Allocate income for several years and determine ending capital
balances)
INCOME ALLOCATION2014
INCOME ALLOCATION2015
Left Center Right Total
Interest(12% of beginning capital above) *$566 $3,888 $3,946 $ 8,400
Salary .................................. 12,000 8,000 -0- 20,000
Remaining income/loss:
$20,000
(8,400)
(20,000)
$(8,400) (2,520) (4,200) (1,680) (8,400)
Totals................... $10,046 $7,688 $2,266 $20,000
*Rounded
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Chapter 09 - Partnerships: Formation and Operation
23. (continued)
INCOME ALLOCATION2016
Left Center Right Total
Interest (12% of beginning capital
above)* ............................ $ 572 $ 3,611 $4,457 $ 8,640
Salary ................................... 12,000 8,000 -0- 20,000
Remaining income:
$40,000
(8,640)
(20,000)
$11,360......................... 2,272 4,544 4,544 11,360
Totals.......................... $14,844 $16,155 $9,001 $40,000
*Rounded
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Chapter 09 - Partnerships: Formation and Operation
24. (12 Minutes) (Determine capital balances after retirement of a partner using
both the goodwill and the bonus approaches)
a. Fergie receives $30,000 more than her capital balance. Because Fergie is
assigned 20 percent of all profits and losses, this extra allocation indicates
total goodwill of $150,000, which must be split among all partners.
b. A $50,000 bonus is paid to Pineda ($280,000 is paid rather than the $230,000
capital balance). This bonus is deducted from the three remaining partners
according to their relative profit and loss ratio (3:2:1). A reduction of 50
percent (3/6) is assigned to Adams or a decrease of $25,000 which drops this
partner's capital balance from $190,000 to $165,000. A reduction of 33.3
percent (2/6) is assigned to Fergie or a decrease of $16,667 which drops this
partner's capital balance from $160,000 to $143,333. A reduction of 16.7
percent (1/6) is assigned to Gomez or a decrease of $8,333 which drops this
partner's capital balance from $140,000 to $131,667.
Because the continuing partners do not wish to record goodwill, a hybrid approach
records identifiable asset fair value changes and corresponding capital
adjustments, but no goodwill. The remaining excess payment to the withdrawing
partner after the revaluation is then treated as a bonus.
Building 40,000
Matteson, capital 12,000
Richton, capital 20,000
OToole, capital 8,000
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Chapter 09 - Partnerships: Formation and Operation
a. The interest factor was probably inserted to reward Hugh for contributing
$50,000 more to the partnership than Jacobs. The salary allowance gives
an additional $20,000 to Jacobs in recognition of the full-time (rather than
part-time) employment. The 40:60 split of the remaining income was
probably negotiated by the partners based on other factors such as
business experience, reputation, etc.
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Chapter 09 - Partnerships: Formation and Operation
26. (continued)
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Chapter 09 - Partnerships: Formation and Operation
CAPITAL BALANCES
A B C D E
Original balances $20,000 $40,000 $ 90,000 $120,000 $-0-
Goodwill (above) 16,200 5,400 21,600 10,800 -0-
Investment -0 - -0 - -0 - -0 - 36,000
Capital balances $ 36,200 $45,400 $111,600 $130,800 $36,000
c. Because E's investment of $42,000 is less than 20% of the resulting capital
($312,000). E is apparently bringing some other attribute to the partnership
(goodwill) that must be computed:
E's investment is, therefore, $42,000 in cash and $25,500 in goodwill for a total
capital balance of $67,500; the other capital accounts remain unchanged. Note
that E's capital of $67,500 is 20% of the new total capital $337,500 ($270,000 +
$67,500).
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Chapter 09 - Partnerships: Formation and Operation
27. (continued)
Bonus from:
A (10%) ................................................................. $1,000
B (30%) ................................................................. 3,000
C (20%) ................................................................. 2,000
D (40%) ................................................................. 4,000 $10,000
CAPITAL BALANCES
A B C D E
Original balances $20,000 $40,000 $90,000 $120,000 $-0-
Investment -0- -0- -0- -0- 55,000
Bonus (above) (1,000) (3,000) (2,000) (4,000) 10,000
Capital balances $19,000 $37,000 $88,000 $116,000 $65,000
Bonus from:
A (1/3) $7,500
B (1/3) 7,500
D (1/3) 7,500 $22,500
CAPITAL BALANCES
A B C D
Original balances ................. $20,000 $40,000 $ 90,000 $120,000
Bonus (above) ...................... (7,500) (7,500) 22,500 (7,500)
Payment ................................ -0 - -0 - (112,500) -0 -
Capital balances ................... $12,500 $32,500 $ -0- $112,500
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Chapter 09 - Partnerships: Formation and Operation
28. (55 Minutes) (Allocation of income to the partners and determination of capital
balances)
ALLOCATION OF INCOME2013
Boswell Johnson Total
Salary (8 months) ................. $8,000 $-0- $ 8,000
Remaining $3,000 ................. 1,200 (40%)
3,000
Totals ................................ $9,200 $1,800 $11,000
ALLOCATION OF INCOME2014
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Chapter 09 - Partnerships: Formation and Operation
28. (continued)
ADMISSION OF POPEJANUARY 1, 2015
Pope's payment was made directly to the partners. Therefore, neither goodwill
nor a bonus need be recognized. Instead, 10% of each capital balance shown
above will be reclassified to Pope. The journal entry would be as follows:
ALLOCATION OF INCOME2015
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Chapter 09 - Partnerships: Formation and Operation
29. (60 Minutes) (Allocate income and prepare a statement of partners' capital)
a. Income Allocation2013
Gray Stone Lawson Totals
Salary allowance ($8 per billable
hour) $13,680 $11,520 $10,400 $35,600
Interest (see Note A) 25,928 21,600 10,800 58,328
Bonus (not applicable because
salary and interest would
necessitate a negative bonus) -0- -0- -0- -0-
Remaining loss (split evenly):
$ 65,000
(35,600)
(58,328)
$(28,928) (9,643) (9,643) (9,642) (28,928)
Profit allocation $29,965 $23,477 $11,558 $65,000
Note A: Interest for Stone and Lawson is calculated at 12% of their beginning
capital balances ($180,000 and $90,000, respectively) while for Gray the
computation is based on a $210,000 balance for 4/12 of the year and $219,100
for the remaining 8/12.
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Chapter 09 - Partnerships: Formation and Operation
29. a. (continued)
Income Allocation2014
Gray Stone Lawson Monet Totals
Salary allowance ($8
per billable hour) $14,400 $ 12,000 $ 11,040 $ 9,520 $ 46,960
Interest (12% of begin-
ning capital balances
for the year) 27,368 22,257 11,107 20,244 80,976
Bonus (not applicable) -0- -0- -0- -0- -0-
Remaining loss (split
evenly):
$ (20,400)
(46,960)
(80,976)
$(148,336) (37,084) (37,084) (37,084) (37,084) (148,336)
Loss allocation $ 4,684 $(2,827) $(14,937) $ (7,320) $(20,400)
Income Allocation2015
Gray Stone Lawson Monet Totals
Salary allowance ($8
per billable hour) $15,040 $12,960 $10,480 $12,640 $ 51,120
Interest (12% of
beginning capital
balances for the
year) 25,193 19,692 8,204 17,341 70,430
Bonus (see Note B) 2,604 2,604 -0- -0- 5,208
Remaining profit split
evenly:
$152,800
(51,120)
(70,430)
(5,208)
$ 26,042 6,510 6,510 6,511 6,511 26,042
Profit allocation $49,347 $41,766 $25,195 $36,492 $152,800
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Chapter 09 - Partnerships: Formation and Operation
29. a. (continued)
Note B: The bonus to Gray and Stone can only be derived algebraically.
Because each of the two partners is entitled to 10% of net income as defined,
the total bonus is 20% and can be computed as follows:
Bonus = 20% (Net income Salary Interest Bonus)
B = .2 ($152,800 $51,120 $70,430 B)
B = .2 ($31,250 B)
B = $6,250 .2B
1.2 B = $6,250
B = $5,208 (or $2,604 per person)
b.
GRAY, STONE, LAWSON, and MONET
Statement of Partners' Capital
For Year Ending December 31, 2015
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Chapter 09 - Partnerships: Formation and Operation
30. (40 Minutes) (Recording admission and retirement of partners using both the
bonus and goodwill methods)
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Chapter 09 - Partnerships: Formation and Operation
30. (continued)
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Chapter 09 - Partnerships: Formation and Operation
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Chapter 09 - Partnerships: Formation and Operation
31. a. (continued)
O'Donnell Reese Dunn
Interest (20% of $51,700
beginning capital balance)........ $10,340
15% of $44,000 income ................... 6,600
60:40 split of remaining $27,060
income ........................................ $16,236 $10,824
Total .................................................. $16,940 $16,236 $10,824
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Chapter 09 - Partnerships: Formation and Operation
31. a. (continued)
1/1/16 Postner, capital ........................................... 33,900
O'Donnell, capital (15%) ............................ 509
Reese, capital (85%) .................................. 2,881
Cash ....................................................... 37,290
(Postner's capital is $33,900 [$22,824
$5,000 + $16,076]. Extra 10% payment is
deducted from the two remaining
partners' capital accounts.)
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Chapter 09 - Partnerships: Formation and Operation
31. b. (continued)
12/31/14 O'Donnell, capital ....................................... 20,000
Reese, capital ............................................. 10,000
Dunn, capital ............................................... 7,500
O'Donnell, drawings.............................. 20,000
Reese, drawings ................................... 10,000
Dunn, drawings ..................................... 7,500
(To close out drawings accounts for the
year based on 20 % of beginning capital
balances: O'Donnell$100,000, Reese
$50,000, and Dunn$37,500.)
12/31/14 Income summary ....................................... 44,000
O'Donnell, capital ................................. 26,600
Reese, capital ........................................ 10,440
Dunn, capital ......................................... 6,960
(To allocate $44,000 income figure as follows)
31. b. (continued)
Postner will be paid $53,562 (110% of the capital balance) for her interest. This
amount exceeds her capital balance by $4,869. Because Postner is only
entitled to a 34% share of profits and losses, the additional $4,869 indicates
that the partnership as a whole is undervalued by $14,321 (4,869 34%). Only
in that circumstance is the extra payment to Postner justified:
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Chapter 09 - Partnerships: Formation and Operation
31. b. (continued)
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Chapter 09 - Partnerships: Formation and Operation
Research Case
This assignment allows the student to make use of the SEC website and, then,
the EDGAR system. It also provides a chance to use actual statements created
for a partnership rather than those typically produced for a corporation.
Analysis Case
One possibility would be to accrue interest to Wilson on her capital balance for
the year based, perhaps, on the prime rate. Poncelet could be assigned a
particularly high share of any revenues generated from new clients. The amount
of income left would result from Higginss work in the day-to-day operations of
the business so a large part of that remainder could be assigned to her.
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Chapter 09 - Partnerships: Formation and Operation
work, one in gaining new clients and the other in the day-to-day operations of the
business.
These two cases ask the student to identify the types of factors that will lend
themselves toward the organization becoming a corporation (in Case 1) or a
partnership (in Case 2). Several issues should be considered when looking into a
legal format for a business enterprise:
Do state laws play any role in the decision? In some states, particular
types of organizations are prohibited from operating as a corporation. Will
state law come into play in making this decision? If so, the partnership
form of organization will be required.
How big do the owners expect the company to become? If the business
will remain small, there may be no need to raise additional capital so that
the ability to sell ownership may not be an issue. This favors creation of a
partnership. However, if Birmingham and Roberts expect the business to
prosper and grow, they should consider which type of business will enable
them to attract other capital or debt investments. Usually, it is a
corporation that is best set up to enable growth through the issuance of
securities.
How risky is the business operation? If the company is operating in a
business where liability is not a significant problem, the limited liability of a
corporation might not be of much interest. However, if there is some risk
involved, the two owners may need the corporate type of organization just
for their own financial security.
How well do the owners know and trust each other? As with the previous
comment, potential liability can be greatly enhanced if the owners do not
know each other well or if additional owners are expected to join at a later
point in time. Under that circumstance, everyone may feel more
comfortable if the business is created as a corporation or as one of the
limited liability organizations. If the owners, though, are comfortable with
each other, they may not feel the necessity of creating a formalized
corporation.
What changes will occur in the tax laws? At this writing, dividends paid by
a corporation to its owners are taxable at 15%. However, from time to time
various politicians have proposed the elimination of part or all of that tax.
Corporations gain appeal if dividend income is not taxed.
How much money do they have available to create a legal organization? In
most states, creation of a partnership can be virtually free whereas the
legal formality of a corporation can cost money. If finances are tight, the
business could begin as a partnership and then convert to a corporation at
a later date as monetary restrictions ease.
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Chapter 09 - Partnerships: Formation and Operation
Excel Case: There are a variety of ways to create a spreadsheet to solve this particular problem.
Here is one possible approach:
In Cell A1, enter text Net Income and in Cell B1 enter $200,000.
In Cell A2, enter text Billable HoursRed. In Cell B2 enter 2,000. In Cell C2, enter $20 hourly rate.
In Cell A3, enter text Billable HoursBlue. In Cell B3 enter 1,500. In Cell C3, enter $30 hourly rate.
In Cell A4, enter text InvestmentRed and in Cell B4 enter $80,000. In Cell C4, enter the rate of
return of 10%.
In Cell A5, enter text InvestmentBlue and in Cell B5 enter $50,000. In Cell C5, enter the rate of
return of 10%.
Perform calculation: In Cell D2, enter formula to multiply number of hours by hourly rate.
Formula: =+B2*C2
The formula for the next three line items is identical to this first formula; copy the formula to Cells
D3, D4, and D5. (To copy a formula across a range of cells, select the cell containing formula,
then drag the fill handle, which is the small square in the lower right corner of this box, over the
adjacent cells. Note that the formula will adjust automatically for the different lines.)
In Cell A6, enter label text Subtotal and SUM the amounts in Cells D2 through D5. Click in Cell
D6, press the symbol on the standard toolbar. Click and drag across the range of cells to be
summed (D2 through D5) and press enter.
Subtract the subtotal of the partners initial allocations (Cell D6) from the Net Income (Cell B1)
with the following formula: In Cell A8, enter the label text Profit to be Split and in Cell D8, enter
the following formula: =+B1-D6.
In Cell A10, enter label text Profit Red and in Cell C10 enter 50%.
In Cell A11, enter label text Profit Blue and in Cell C11 enter 50%.
Perform calculations: In Cell D10, enter formula to multiply Profit to be Split (Cell D8) by
distribution percentage (Cell C10). Formula: =+D8*C10
Repeat this calculation for the other partner. In Cell D11, enter the formula: =+D8*C11
Once the spreadsheet is created, any variable may be changed and the results will adjust
automatically. There are eleven variables that can be changed: B1, B2, B3, B4, B5, C2, C3, C4,
and C5, as well as C10 and C11 (which must add up to 100%).
Example:
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Chapter 09 - Partnerships: Formation and Operation
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