Professional Documents
Culture Documents
Partnerships: Formation,
Operation, and Changes in
Membership
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Comprehensive Partnership Creation Problem
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What is a Partnership?
An association of two or
more persons who
A B
are co-owners of a
business, and
share profits and losses
in an agreed-upon
manner. ABC
Company
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What is a “Person”?
An individual
A corporation
Another partnership
T&D
Z Corp
Partnership
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Partnerships: Pros & Cons
Advantages
Ease of formation
Lack of formality
Single taxation (see following slide)
Disadvantages
Unlimited liability (for general partnerships)
Difficulty in disposing of partnership interests
Mutual agency
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Partnership Form of Organization: Income Tax
Reporting
Single Taxation of Partnership
Earnings
Partnerships only report their Uncle Sam
earnings—they are not taxed at the
business entity level (as are
corporations).
A B
Partnerships file IRS Form 1065,
which shows the allocation of profits
among partners. AB
Partners report their share of profits Partnership
on their individual IRS Form 1040
return.
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Regulation
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Regulation: The Uniform Partnership Act (UPA)
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The Partnership Agreement
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Practice Quiz Question #1 Solution
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Learning Objective 2
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Types of Partnerships
General Partnerships
All partners have unlimited liability.
Creditors can go after the personal assets of
any or all of the partners.
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Types of Partnerships
Limited Partnerships
Limited partners have limited liability to
partnership creditors if the partnership is unable
to pay its debts.
Limited partners’ risk is limited to their invested
capital.
Thus, personal assets are not at risk.
At least one of the partners must be a general
partner.
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Types of Partnerships
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Types of Partnerships
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Practice Quiz Question #2 Solution
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Learning Objective 3
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Partners’ Accounts
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Recording Capital Contributions
Keep it FAIR!
Current Fair Market
Values should be used to
record
noncash assets contributed
to a partnership.
liabilities assumed by a
partnership. ABC
Partnership
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Partnership Formation Example
Allocate to:
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Comprehensive Problem Solution
Brad & Mike Journal Entry:
Cash 25,000
Accounts Receivable 100,000
Allowance for doubtful accounts 3,000
Inventory 175,000
Building & Equipment 73,500
Accounts Payable 40,000
Notes Payable 100,000
Brad, Capital 91,600
Mike, Capital 138,900
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Comprehensive Problem Solution
Austin & Justin Journal Entry:
Cash 22,000
Accounts Receivable 150,000
Allowance for doubtful accounts 18,000
Inventory 140,000
Building & Equipment 112,000
Accounts Payable 61,500
Notes Payable 120,000
Austin, Capital 71,150
Justin, Capital 153,350
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Comprehensive Problem Solution
PART 2
Capital contribution or
(600) (2,400) (2,900) 5,900
(withdrawal)
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Learning Objective 4
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Accounting for Operations of a Partnership
Partners’ accounts
Capital accounts
Used to record the initial investment of a partner, any
subsequent capital contributions, profit or loss
distributions, and any withdrawals of capital by the
partner
Deficiencies are usually eliminated by additional
capital contributions
Capital
Investment
Contributions
% Loss % Profit
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Accounting for Operations of a Partnership
Partners’ accounts
Drawing accounts
Used to record periodic withdrawals and is then
closed to the partner’s capital account at the end of
the period
Noncash drawings are valued at their market values
at the date of the withdrawal
Loan accounts
A loan from a partner is shown as a payable on the
partnership’s books
Unless all partners agree otherwise, the partnership
is obligated to pay interest on the loan
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Practice Quiz Question #3
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Practice Quiz Question #3 Solution
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Learning Objective 5
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Income Allocation Example
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Sharing Profits and Losses
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Group Exercise 1: Allocating Profit and Loss,
No Restrictions
The partnership of Alex and James has the following provisions:
• Alex and James receive salary allowances of $37,000 and $18,000,
respectively.
• Interest is imputed at 10% on the average capital investment.
• Any remaining profit or loss is shared between Alex and James in
a 3:2 ratio, respectively.
• Average Capital investments: Alex, $ 50,000; James, 130,000
REQUIRED
1. Prepare a schedule showing how the profit would be divided,
assuming the partnership profit or loss is:
a. $ 102,000
b. $ 57,000
c. $(34,000)
2. What journal entry should be made to allocate the profit or loss
for each of the three cases listed above?
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Group Exercise 1: Solution for part a
ALLOCATED TO
Alex James Total
Total Profit 102,000)
Salary 37,000 18,000 (55,000
Interest on Capital 5,000 13,000 (18,000
Residual Profit 29,000
Allocate Profit 17,400 11,600 (29,000
59,400 42,600 0
Income Summary 102,000
Capital, Alex 59,400
Capital, James 42,600
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Group Exercise 1: Solution for part b
ALLOCATED TO
Alex James Total
Total Profit 57,000)
Salary 37,000) 18,000) (55,000)
Interest on Capital 5,000) 13,000) (18,000)
Residual Profit (16,000)
Allocate Profit (9,600) (6,400) 16,000)
32,400) 24,600) 0)
Income Summary 57,000
Capital, Alex 32,400
Capital, James 24,600
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Group Exercise 1: Solution for part c
ALLOCATED TO
Alex James Total
Total Profit (34,000)
Salary 37,000) 18,000) (55,000)
Interest on Capital 5,000) 13,000) (18,000)
(107,000)
Residual Profit
Allocate Profit (64,200) (42,800) 107,000)
(22,200) (11,800) 0)
Capital, Alex 22,200
Capital, James 11,800
Income Summary 34,000
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Methods to Share Profits and Losses: “To the
Extent Possible” Limitations
When a “limit” provision exists:
The next lower level method of sharing can be
reached if and only if there is still unallocated
profit remaining after dealing with the current
level.
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Group Exercise 2: Allocating Profit and Loss—
“Limit”
Assume the same information provided in Group Exercise 1, except that the partnership
agreement stipulates the following order of priority:
1.Salary allowances (only to the extent available)
2.Imputed interest on average capital investments (only to the extent available).
3.Any remaining profit in a 3:2 ratio. (No mention is made regarding losses.)
REQUIRED:
The requirements are the same as for Group Exercise 1 (i.e., calculate the allocations and
prepare journal entries).
a. $ 102,000
b. $ 57,000
c. $ (34,000)
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Group Exercise 2: Solution for part a
ALLOCATED TO
Alex James Total
Total Profit 102,000)
Salary 37,000) 18,000) (55,000)
Interest on Capital 5,000) 13,000) (18,000)
Residual Profit 29,000)
Allocate Profit 17,400) 11,600) (29,000)
59,400) 42,600) 0)
Income Summary 102,000
Capital, Alex 59,400
Capital, James 42,600
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Group Exercise 2: Solution for part b
ALLOCATED TO
Alex James Total
Total Profit 57,000)
Salary 37,000) 18,000) (55,000)
2,000)
Interest on Capital * 556) 1,444) (2,000)
Residual Profit 0)
Allocate Profit 0) 0) 0)
37,556) 19,444) 0)
* $2,000 x (5,000 ÷ $18,000) = 556
$2,000 x ($13,000 ÷ $18,000) = 1,444
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Practice Quiz Question #4
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Partner’s Admission: Purchase of An Existing
Interest
The purchase of an interest from
one or more of a partnership’s C
existing partners is a:
personal transaction between the Interest $
incoming partner and the selling
partner(s).
The only entry required on the
A B
partnership’s books is to transfer
an amount:
from the selling partner’s Capital AB
account. Partnership
to the new partner’s Capital account.
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Partner’s Admission: Adding a New Partner
Key Objective
Achieve equity among the partners
+ =
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How to Achieve Equity?
+ =
Example
Cash $100,000 Capital, A $100,000
Land 100,000 Capital, B 100,000
Total Assets $200,000 Total Equity $200,000
Example
Cash $100,000 Capital, A $100,000
Land 100,000 Capital, B 100,000
Total Assets $200,000 Total Equity $200,000
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Minimizing Inequities
Land 100,000
Capital, A 50,000
Capital, B 50,000
Cash 150,000
Capital, C 150,000
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(2) Bonus Method
Q: Given that the land has a current value of $200,000?
Cash 150,000
Capital, A 16,667
Capital, B 16,667
Capital, C 116,667
Cash 150,000
Capital, C 150,000
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Summary of the Three Methods: Before Land
is Sold for $230,000
(1) Revaluing Cash $250,000 Capital, A $150,000
of assets Capital, B 150,000
Land 200,000 Capital, C 150,000
Total Assets $450,000 Total Equity $450,000
Gain of $30,000 allocated equally to A, B, & C ($10,000 each)
(2) Bonus Cash $250,000 Capital, A $116,667
Capital, B 116,667
Land 100,000 Capital, C 116,667
Total Assets $350,000 Total Equity $350,000
Gain of $130,000 allocated equally to A, B, & C ($43,333 each)
(3) Special Cash $250,000 Capital, A $100,000
P&L Capital, B 100,000
Sharing Land 100,000 Capital, C 150,000
Total Assets $350,000 Total Equity $350,000
Gain of $130,000: allocate $60,000 to A & B and $10,000 to C
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Summary of the Three Methods: After Land is
Sold for $230,000
(1) Revaluing Cash $480,000 Capital, A $160,000
of assets Capital, B 160,000
Capital, C
160,000
Total Assets $480,000 Total Equity $480,000
(2) Bonus Cash $480,000 Capital, A $160,000
Capital, B 160,000
Capital, C
160,000
Total Assets $480,000 Total Equity $480,000
≠
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Key Differences Between Revaluation /
Goodwill and Bonus Methods
Revaluation/Goodwill Method
Excess Value
Revalue the balance sheet by
recording goodwill or revaluing
Book Value
tangible assets. of Net Assets
Thus, we now have a bigger “pie”
to divide up among the partners.
Land 100,000
Capital, A 50,000
Capital, B 50,000
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Key Differences Between Revaluation /
Goodwill and Bonus Methods
Revaluation/Goodwill Method
Land = $100,000
Revalue the balance sheet by
recording goodwill or revaluing Small Pie =
200,000 +
tangible assets. 150,000 =
350,000
Thus, we now have a bigger “pie”
to divide up among the partners.
The new partner’s capital account x 1/3 =
$150,000
will be equal to his/her ownership
percentage of the “Big Pie.”
Cash 150,000
Capital, C 150,000
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Key Differences Between Revaluation /
Goodwill and Bonus Methods
Bonus Method
Do not revalue the balance sheet.
Only leaves the book value of Book Value
tangible net assets on the balance of Net Assets
sheet.
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Key Differences Between Revaluation /
Goodwill and Bonus Methods
Bonus Method
Do not revalue the balance sheet.
Small Pie =
Only leaves the book value of 200,000 +
tangible net assets on the balance 150,000 =
sheet. 350,000
Advantages
Credit to incoming partner always at least
equal to cash contribution
Can be important “psychologically”
Disadvantages
Departs from GAAP
Complicates income tax preparation
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The Bonus Method
Major Advantages
Does not result in a departure from GAAP
Minimizes bookkeeping and tax return effort
Major Disadvantages
A portion of one or more partner’s capital balance
is transferred to one or more other partners.
The hope is that the transferred amount will later be
recouped via future profits.
Incoming partner’s capital account may be less
than his/her cash contribution!
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Determining the Value of Goodwill
Steps to follow:
1. Estimate the implied value of the partnership based on
the new partner’s contribution.
New capital contribution ÷ new partner ownership %
2. Estimate the implied value of the partnership based on
the old partners’ total equity.
Total old partner capital balance ÷ total old ownership %
3. Calculate the amount of tangible net assets.
The sum of old partner capital and new partner contributed
capital.
4. Calculate implied goodwill
Implied value (greater of 1 or 2) – tangible net assets (3)
5. Determine whether the new or old partners possess
goodwill.
The smaller of 1 or 2
The one who paid less for their relative share.
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Practice Quiz Question #5a
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Solution, Summary
1. New implied value: $ 54,000 ÷ 25% = $ 216,000
2. Old implied value: $180,000 ÷ 75% = $ 240,000
3. Tangible net assets: $180,000 + $54,000 = $ 234,000
4. Implied Goodwill = $240,000 $234,000 = $ 6,000
5. Goodwill belongs to new partner (because
$216,000 is less than $240,000). [Implies that
she paid less for her relative share of the business.]
Since we’re evaluating, use the BIG pie:
x 25% = $60,000
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Practice Quiz Question #5a Solution
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Solution, Summary
1.New implied value: $ 54,000 ÷ 25% = $ 216,000
2.Old implied value: $180,000 ÷ 75% = $ 240,000
3.Tangible net assets: $180,000 + $54,000 = $ 234,000
4.Implied Goodwill = $240,000 $234,000 = $ 6,000
5.Goodwill belongs to new partner (because
$216,000 is less than $240,000). [Implies that
she paid less for her relative share of the business.]
Since we’re evaluating, use the BIG pie:
Since we’re not
revaluating, use the The BIG PIE (Tangible + Goodwill)
Small pie:
The SMALL PIE (Tangible Only)
Small Pie
= 180,000
+ 54,000
= 234,000 x 25% = $58,500
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Practice Quiz Question #5b Solution
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Group Exercise: Goodwill Method
Scott and Stephanie are partners with capital balances of $100,000 and
$65,000, and they share profits and losses in the ratio of 3:2, respectively.
Zoe invests $60,000 cash for a 25% interest in the capital and profits of
the new partnership. The partners agree that the implied partnership
goodwill is to be recorded simultaneously with the admission of Zoe.
REQUIRED
1.Calculate the firm’s total implied goodwill.
2.Prepare the entry or entries to record the admission of Zoe.
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Solution, Summary
1. New implied value: $ 60,000 ÷ 25% = $ 240,000
2. Old implied value: $165,000 ÷ 75% = $ 220,000
3. Tangible net assets: $165,000 + $60,000 = $ 225,000
4. Implied Goodwill = $240,000 $225,000 = $ 15,000
5. Goodwill belongs to old partners (because
$220,000 is less than $240,000). [Implies that
they “gave” less for her relative share of the business.]
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Group Exercise: Goodwill Method Solution
x 25% = $60,000
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Group Exercise: Bonus Method
Jim and June are partners who share profits and losses in the ratio of
2:1, respectively. On 12/31/X8 their capital accounts are as follows:
Jim $ 40,000
June 30,000
Total $ 70,000
On that date, they agreed to admit Mel as a partner with a 30%
interest in the capital and profits and losses for an investment of
$15,000. The new partnership will begin with total capital of
$85,000.
REQUIRED
Prepare the entry or entries to record the admission of Mel.
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Solution, Summary
1. New implied value: $ 15,000 ÷ 30% = $ 50,000
2. Old implied value: $ 70,000 ÷ 70% = $ 100,000
3. Tangible net assets: $ 70,000 + $15,000 = $ 85,000
4. Implied Goodwill = $100,000 $85,000 = $ 15,000
5. Goodwill belongs to new partner (because
$50,000 is less than $100,000). [Implies that
he “gave” less for his relative share of the business.]
Note that we use the small pie here with bonus method.
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Group Exercise: Goodwill Method Solution
GW = 10,000
The BIG PIE (Tangible + Goodwill)
60,000 +
25,000 =
85,000 The SMALL PIE (Tangible Only)
Land = 30,000
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Comprehensive Group Problem Solution
PART 1 (Revaluation / Goodwill Method):
To record goodwill.
Land 30,000
Capital, Jenn 26,250
Capital, Amanda 3,750
Goodwill 10,000
Capital, Jenn 8,750
Capital, Amanda 1,250
Cash 25,000
Capital, Tommy 25,000
GW = 10,000
60,000 +
25,000 = Note that this
85,000 is 20% of the
Land = 30,000 x 20% = $25,000 “Big Pie.”
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Comprehensive Group Problem Solution
PART 2 (Bonus Method):
If the partnersh ip were sold one day after Tommy was admitted and the selling p rice was $40,000 more than th e book value of the net assets, Tommy would share in th e $40,000 gain to the extent of $8,000 (2 0% × $40,000), the amount of his capital contribution that is given as a bonus to Jenn and Amanda.
Cash 25,000
Capital, Jenn 7,000
Capital, Amanda 1,000
Capital, Tommy 17,000
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Legal Aspects: Joining a Partnership
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Legal Aspects: Withdrawing from a Partnership
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Legal Aspects: Withdrawing from a Partnership
Disassociation
A broad term that refers to when a partner is no
longer associated with a partnership.
Dissolution
A narrow term that refers to when a
(1) partnership is dissolved, and
(2) its affairs must be wound up.
Thus, the partnership’s existence is terminated.
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Practice Quiz Question #6
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Solution
20%
Total Goodwill $20,000
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Practice Quiz Question #6 Solution
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Group Exercise: Retirement
The 6/30/X8 balance sheet of the partnership of Sandy, Rees, and Raymond as
follows. The partners share profits and losses in the ratio of 2:2:6, respectively.
Assets at cost $145,000
Sandy, loan 9,000
Other liabilities 17,000
Capital, Sandy 20,000
Capital, Rees 37,000
Capital, Raymond 62,000
Sandy retires from the partnership. By mutual agreement, the assets are to be
adjusted to their fair value of $150,000 at 6/30/X8. Rees and Raymond agree that
the partnership will pay Sandy $45,000 cash for her partnership interest, exclusive
of her loan, which is to be paid in full. No goodwill is to be recorded.
REQUIRED
1.Prepare the entry to record the revaluation of assets to fair value.
2.Prepare the entry to record Sandy’s retirement.
3.What is the implicit total goodwill for the partnership?
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Group Exercise Solution
PART 1
Assets 5,000
Capital, Sandy 1,000
Capital, Rees 1,000
Capital, Raymond 3,000
To revalue assets to their current value.
PART 2
Capital, Sandy 21,000
Capital, Rees 6,000
Capital, Raymond 18,000
Cash 45,000
To record the withdrawal of Sandy.
PART 3
Sandy received a bonus of $24,000, which was equal to her share of the
goodwill. Because Sandy’s profit and loss sharing ratio was 20%, the total
goodwill must have been $120,000 ($24,000 ÷ 20%). 15-92
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Conclusion
The End
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