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

ID: 2480347 • Letter: S

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, 2013, O’Donnell invests a building worth $108,000 and equipment valued at $64,000 as well as $98,000 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 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 2013. Thereafter, each can draw $9,000 annually or 15 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, 2014, Terri Dunn becomes a third partner in this business by contributing $21,000 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 2014 is reported as $82,000. Each partner withdraws the full amount that is allowed.

On January 1, 2015, Dunn becomes ill and sells her interest in the partnership (with the consent of the other two partners) to Judy Postner. Postner pays $150,000 directly to Dunn. Net income for 2015 is $80,000 with the partners again taking their full drawing allowance.

On January 1, 2016, 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 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.

1. Record the initial investment to assets by partners
2. Record the interest amount paid to O'Donnell and loss to Reese capital
3. Record the cash and goodwill contributed by Dunn
4. Record entry to close drawings accounts.
5. Record the distribution of net income to partners
6. Record the goodwill purchased by Dunn
7. Record the reclassification of capital interest to new partner
8. Record entry to close drawings accounts
9. Record the distribution of net income to partners
10. Record the recognition implied goodwill
11. Record the final distribution to Postner

Explanation / Answer

Answer:

1. 1/01/13

Building Dr. 108000

Equipment Dr. 64000

Cash Dr. 98000

Goodwill Dr. 270000

To O'Donnell, capital............270000

To Reese, capital................270000

( To record initial capital investment. Reese is credited with goodwill of $270000 to match O'Donnell, capital investment)

2. 12/31/13

Reese, capital Dr.43000

To O'Donnell, capital...........35000

To income summary...........8000

( interest of $27000 is credited to O'Donnell (270000 *10%) along with a base of $8000. The remaining amount is now a $43000 loss that is entirely attributable to Reese)

3. 1/01/14

Cash Dr. 21000

Goodwill Dr. 112000

To Dunn, capital............133000

(Cash and goodwill being contributed by Dunn are recorded. goodwill must be calculated algebraically;see working note below)

Working note:

Current capital is calculated as:

O'Donnell, capital (270000+35000) = 305000

Reese, capita (270000-43000) = 227000

Total = 532000

Calculation of goodwill contributed by Dunn:

21000 cash + goodwill = 20% (Current capital + Cash + goodwill)

21000 cash + goodwill = 20% ( 532000 + 21000+ goodwill)

21000 cash + goodwill = 110600 + 0.2 goodwill

0.8 goodwill =89600 (110600 -21000)

goodwill = 89600/0.8= $112000

4. 12/31/14

O'Donnell, capital Dr.45750

Reese, capital Dr. 34050

Dunn, capital Dr. 19950

To O'Donnell, drawings .........45750

To Reese, drawings..............34050

To Dunn, drawings.................19950

(to close out the drawings accounts for the year based on 15% of beg. capital balances : O'Donnell - 305000, Reese - 227000, Dunn -133000)

5. 12/31/14

Income summary Dr. 82000

To O'Donell, capital.....................38700

To Reese, capital........................21650

To Dunn, capital..........................21650

(To allocate $82000 income figure as follows)

O’Donnell

Reese

Dunn

Interest (10% of $305000 beginning capital balance)

30500

10% of $82000 income

8200

50:50 split of remaining $43300

21650

Totals

38700

21650

Capital balances as of 12/31/14:

O’Donnell

Reese

Dunn

Initial 2013 investment

270000

2013 profit allocation

35000

(43000)

Additional investment

133000

2014 drawings

(45750)

(34050)

(19950)

2014 profit allocation

38700

21650

12/31/14 balances

297950

214600

134700

6. 1/01/15

goodwill Dr.34000

To O'Donnell, capital .............3400

To Reese, capital..................15300

To Dunn, capital ...................15300

(to record goodwill indicated by purchase of Dunn's interest)

In effect, profits are shared 10% to O'Donnell, 45% to Reese (50% of the 90% remaining after O'Donnell's income), 45% to Dunn ( 50% of the 90% remaining after O'Donnell's income). Pstner is paying $150000, an amount $15300 in excess of the Dunn's capital (134700). The additional payment for this 45% income interest indicates total goodwill of $34000 ( 15300/45%). because Dunn is entitled to 45% of the profits but only holds 20%[134700/(134700+214600+297950) = 134700 / 647250 = 20%] of the total capital, an implied value for the company as a whole cannot be determined directly from the payment of $150000. Thus, goodwill can only be computed on the basis of excess payment.

7. 1/01/15

Dunn, capital Dr. 150000

To Pstner capital............150000

(to reclassify capital balance to new partner)

8. 12/31/15

O'Donnell, capital Dr. 45203

Reese, capital Dr. 34485

Postner, capital Dr. 22500

To O'Donnell, drawings.............45203

To Reese, drawings..................34485

To Postner, drawings.................22500

[to close out the drawings account for the year based on 15% of the beginning capital balances (after adjustment for goodwill) : O'Donnell - 301350 (297950+3400) , Reese - 229900 (214600+15300) , Postner - 150000]

9. 12/31/15

Income summary Dr. 80000

To O'Donnell, capital.............33615

To Reese, capital..................23192.5

To Postner, capital................23192.5

(to allocate profit for 2015 as follows)

O’Donnell

Reese

Postner

Interest (10% of $256147 (301350 – 45203) beginning capital balance)

25615

10% of $80000 income

8000

50:50 split of remaining $46385

23192.5

Totals

33615

23192.5

Capital balances as of 12/31/15 as follows:

O’Donnell

Reese

Postner

12/31/14 balances

297950

214600

134700

Adjustment for goodwill

3400

15300

Drawings

(45203)

(34485)

(22500)

Profit allocation

33615

23192.5

12/31/15 balances

289762

218607.5

150692.5

10. 1/01/16

Goodwill Dr. 33487

To O’Donnell, capital (10%) ............3349

To Reese, capital (45%)...................15069

To Pstner, capital (45%)..................15069

(to recognise implied goodwill)

Postner will be paid $165761.75 (110% of the capital balances) for her interest. This amount is $15069.25 in excess of the capital account. Because Postner is only entitled to a 45% share of profits and losses, the additional $15069.25 must indicate that the partnership as a whole is undervalued by $33487 (15069.25/45%). Only in that circumstances would the extra payment to Postner be justified.

11.1/01/16

Postner, capital Dr. 165761.75

To cash............................165761.75

(To record final distribution to Postner).

O’Donnell

Reese

Dunn

Interest (10% of $305000 beginning capital balance)

30500

10% of $82000 income

8200

50:50 split of remaining $43300

21650

Totals

38700

21650

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