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Partnerships: Formation and Operation: Answers To Questions
Partnerships: Formation and Operation: Answers To Questions
Answers to Questions
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.
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.
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 since 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. Any goodwill being recognized in a capital transaction that is allocated to the original
partners is 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.
Answers to Problems
1. B
2. C
4. D The implied value of the company based on the new contribution is only
$233,333 ($70,000/30%) which is below the total of the capital balances
($280,000 in original capital plus $70,000 to be invested). Thus, either the
assets are overvalued or the new partner is also contributing goodwill.
Since the problem indicates that goodwill is being recognized, that figure
must be computed. Note that the $70,000 is going into the business and,
thus, increases capital.
9. D ASSIGNMENT OF INCOME2007
ARTHUR BAXTER CARTWRIGHT TOTAL
Interest10% of
beginning capital ............... $ 6,000 $ 8,000 $10,000 $24,000
Salary........................................ 20,000 20,000
Allocation of remaining income
($6,000 divided on a 3:3:4 basis) 1,800 1,800 2,400 6,000
Totals ............................. $ 7,800 $29,800 $12,400 $50,000
STATEMENT OF CAPITAL2007
ARTHUR BAXTER CARTWRIGHT TOTAL
Beginning capital .................... $60,000 $80,000 $100,000 $240,000
Net income (above) ................. 7,800 29,800 12,400 50,000
Drawings (given) ..................... (5,000) (5,000) (5,000) (15,000)
Ending capital ......................... $62,800 $104,800 $107,400 $275,000
11. A A $10,000 bonus is paid to Costello ($100,000 is paid rather than the
$90,000 capital balance). This bonus is deducted from the two remaining
partners according to their profit and loss ratio (2:3). A reduction of 60
percent (3/5) is assigned to Burns or a decrease of $6,000 which drops that
partners capital balance from $30,000 to $24,000.
Montana is assigned 30% of all profits and losses and would, therefore,
record $15,000 of this goodwill, an entry that raises this partner's capital
balance from $130,000 to $145,000.
13. A The implied value of the company is $900,000 ($270,000/30%). Since 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 must be 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.
14. D Since 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.
15. (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
b. Bonus Method
Total capital after investment ($70,000 + 40,000 + $80,000) $190,000
Ownership portionLear ................................................ 40%
Lear, capital ...................................................................... $ 76,000
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. Since $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 to be 25 percent, this partner's
capital balance would be $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%).
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. Since 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
18. (8 Minutes) (Record admission of new partner and allocation of new income)
Part a.
Total capital is $336,000 ($150,000 + $110,000 + $76,000) after the new
investment. However, the implied value of the business based on the new
investment is $380,000 ($76,000/20%). Consequently, goodwill of $44,000
must be recognized with the offsetting allocation to the original two
partners based on their profit and loss ratio: Com$26,400 (60%) and Pack
$17,600 (40%).
Goodwill.................................................................. 44,000
Com, Capital ..................................................... 26,400
Pack, Capital .................................................... 17,600
Cash ...................................................................... 76,000
Hal, Capital ....................................................... 76,000
Part b.
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)
INCOME ALLOCATION2009
INCOME ALLOCATION2010
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
*Rounded
b. A $50,000 bonus is paid to Lennon ($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 McCartney 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 Harrison 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 Starr or a decrease of $8,333 which drops this
partner's capital balance from $140,000 to $131,667.
23. (45 Minutes) (Discussion of P&L allocations and admission of a new partner)
a. The interest factor was probably inserted to reward Page for contributing
$50,000 more to the partnership than Childers. The salary allowance gives
an additional $15,000 to Childers 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.
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. Since 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).
24.(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
25. (55 Minutes) (Allocation of income to the partners and determination of capital
balances)
ALLOCATION OF INCOME2008
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 INCOME2009
ALLOCATION OF INCOME2010
a. Income Allocation2009
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.
Income Allocation2011
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
26. a. (continued)
Note B: The bonus to Gray and Stone can only be derived algebraically. Since
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, AND LAWSON
Statement of Partners' Capital
For Year Ending December 31, 2009
28. b. (continued)
implied value for the company as a whole cannot be determined directly from
the payment of $46,000. Thus, goodwill can only be computed based on the
excess payment.
28. b. (continued)