Find more slides, ebooks, solution manual and testbank on www.downloadslide.com CHAPTER 14 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 II Partnership accounting and the capital accounts A The distinctive aspects of partnership accounting center on the capital accounts maintained for each individual partner B The basis of accounting for these capital balances is the Articles of Partnership agreement which establishes provisions for initial investments, withdrawals, admission of a new partner, retirement of a partner, etc C The actual contribution made by the partners to the business should be recorded at fair market value A problem arises, however, when a contribution is truly intangible such as a particular expertise or an established client base In the bonus method, only identifiable assets are valued and recorded The capital account balances are then aligned to indicate the percentage of the actual contributions being made by each partner In the goodwill method, the amount being contributed and the corresponding percentage of the initial capital balance are used to calculate the value of the business and the presence of goodwill, a figure which is physically recorded as an intangible asset III Allocation of income A At the end of each fiscal period, the revenue and expense accounts must be closed out with the resulting income figure being assigned to the individual capital accounts B The method of allocating income to the capital accounts should be established within the Articles of Partnership Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-1 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com The partners can simply assume an equal division of profits and losses 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 IV Accounting for partnership dissolution A Over time, the identity of the individuals within a partnership can change through admission of a new partner or the death, retirement, or withdrawal of a present partner B Each change in composition serves to dissolve the original partnership usually so that a new partnership can be formed to continue the business Thus, dissolution does not necessarily affect the operations of the business C Admission of a new partner A new partner will often buy all (or a portion) of the interest owned by one or more of the present partners a The capital account balances can simply be reclassified to reflect the identity of the new ownership b As an alternative, all accounts may be adjusted to fair market value with the price paid being used as the basis for calculating any goodwill A new partner can also be admitted by a direct contribution to the partnership business a The bonus (or no revaluation) method records the identifiable assets being contributed at fair market value The new partner’s capital is set equal to a prearranged percentage or amount The remaining capital balances are then aligned based on profit and loss percentages b The goodwill (or revaluation) approach initially adjusts all assets and liabilities of the partnership to fair market value and records goodwill based on the amount being paid (which is used to calculate the implied value of the business) D Withdrawal of a partner The final asset distribution to an individual should be based on the agreement established in the Articles of Partnership and will often vary in amount from that partner's ending capital balance The difference between the amount paid and the final capital balance can simply be recorded as an adjustment to the remaining partners' capital accounts in the same manner as the bonus method As an alternative, all accounts can be adjusted to fair value with the amount of payment being used as the basis for computing goodwill Irwin/McGraw-Hill 14-2 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Learning Objectives Having completed Chapter 14 of this textbook, "Partnerships: Formation and Operation," students should be able to fulfill each of the following learning objectives: Discuss the advantages and disadvantages of organizing a business as a partnership instead of as a corporation including such factors as the ease of formation, taxation effects, and the unlimited liability of the partners Describe the purpose of an Articles of Partnership and list specific items that should be included in this agreement Prepare the journal entry to record the initial capital investment made by a partner when either cash or another asset is being contributed Use both the bonus method and the goodwill method to record a capital investment made by a partner who is contributing an attribute such as a specific expertise or an established clientele Understand the impact that the allocation of income earned by a partnership has on the individual capital balances Allocate income to partners when interest and/or salary factors are included Discuss the meaning of a partnership dissolution and understand that a dissolution will often have little or no effect on the operations of the partnership business Prepare journal entries to record the acquisition by a new partner of a current partner's interest These entries should be made both as a reclassification as well as by means of the goodwill approach Prepare journal entries to record a new partner's admission by a contribution made directly to the partnership These entries should be made both by the bonus method as well as by the goodwill method 10 Prepare journal entries to record the withdrawal of a current partner These entries should be made by the bonus method, the goodwill method, or a modified method whereby assets and liabilities are revalued but no goodwill is recognized Answers to Discussion Questions What Kind of Business is This? The owners of this business face a common problem: they have started operations without giving serious consideration to the legal formation of the company The accountant now needs to spell out for them the advantages and disadvantages of creating a partnership versus a Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com corporation or some other type of legal form Eventually, the owners must make this decision but they should consider all of the relevant factors before arriving at their choice The accountant should discuss the following issues with the two owners: —Ease of formation A formal partnership can be created by the writing of an Articles of Partnership If the allocation of income and the contributions by the partners have already been resolved, the development of this document should be relatively simple Forming a corporation can be a more difficult task but the degree of difficulty does depend on individual state laws Normally, the documents to be completed are more complicated although that is not necessarily so The accountant should explain the specific procedures that apply to partnerships in the state where the business is organized and conducts its operations —Business liabilities In a partnership, either partner may be held liable for all business debts Thus, if liabilities escalate and the business fails, each partner does risk the possible loss of an enormous sum The same problem would not exist in a corporation where owners and the business are considered 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 seem to have less risk than a pharmaceutical company The concept of personal liability for business debts becomes especially important in a business with a high possibility of litigation and resulting losses In a business with such a risk, creating a corporation to protect the personal property of the stockholders would appear to be a wise move The owners of a partnership might become personally responsible for losses created by a business mistake or accident Obviously, this need for responsibility is recognized in states that prohibit doctors, lawyers, accountants, and the like from incorporating This is a primary reason for such states to 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 Corporation—a business that is incorporated but still taxed as a partnership Irwin/McGraw-Hill 14-4 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com —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 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 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 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? How Will the Profits Be Split? 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 Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 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 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 Irwin/McGraw-Hill 14-6 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions 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, since 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 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 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 Subchapter S corporation is formed legally as a corporation so that its owners enjoy limited legal liability and easy transferability of ownership However, if a company qualifies and becomes a Subchapter S Corporation, it will be taxed in virtually the same manner as a partnership Hence, income will be taxed only once and that is to the owners at the time that it is earned by the corporation Use of this designation is quite restricted To qualify as a Subchapter S Corporation, a company can only have one class of stock and must have no more than 100 owners These owners can only be individuals, estates, certain tax-exempt entities, and certain types of trusts Most corporations that not qualify as Subchapter S Corporations are automatically Subchapter C Corporations These entities are also corporations but they pay income taxes when the income is earned Additionally, the owners are liable for a second income tax when dividends are distributed to them Thus, the income earned by a Subchapter C Corporation faces the double taxation effect commonly associated with corporations 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 Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com advantage of a general partnership is that all income earned by the business is only taxed 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 partner’s 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 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: a b c d e Name and address of each partner Business location Description of the nature of the business Rights and responsibilities of each partner Initial investment to be made by each partner along with the method to be used for valuation f Specific method by which profits and losses are to be allocated g Periodic withdrawals to be allowed each partner h Procedure for admitting new partners i Method for arbitrating partnership disputes j Method for settling a partner's share in the business upon withdrawal, retirement, or death 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 partner’s book value is retained 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 Irwin/McGraw-Hill 14-8 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 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 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: Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com a The right of co-ownership of the business property; b The right to a specified allocation of profits and losses generated by the partnership's business; and c The right to participate in the management of the business 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 Irwin/McGraw-Hill 14-10 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 26 a (continued) Income Allocation—2010 Gray Salary allowance ($8 per billable hour) $14,400 Interest (12% of beginning capital balances for the year) 27,368 Bonus (not applicable) -0Remaining loss (split evenly): $ (20,400) (46,960) (80,976) $(148,336) (37,084) Loss allocation $ 4,684 Stone Lawson Monet Totals $ 12,000 $ 11,040 $ 9,520 $ 46,960 22,257 -0- 11,107 -0- 20,244 -0- 80,976 -0- (37,084) $(2,827) (37,084) $(14,937) (37,084) $ (7,320) (148,336) $(20,400) Capital Account Balances 1/1/10 – 12/31/10 Gray Stone Beginning balances $228,065 $185,477 Loss allocation (from above) 4,684 (2,827) Drawings (10% of beginning balances) (22,806) (18,548) Ending balances $209,943 $164,102 Income Allocation—2011 Gray Salary allowance ($8 per billable hour) $15,040 Interest (12% of beginning capital balances for the year) 25,193 Bonus (see Note B) 2,604 Remaining profit split evenly: $152,800 (51,120) (70,430) (5,208) $ 26,042 6,510 Profit allocation $49,347 Irwin/McGraw-Hill 14-30 Lawson $92,558 Monet $168,700 Totals $674,800 (14,937) (7,320) (20,400) (9,256) $68,365 (16,870) $144,510 (67,480) $586,920 Stone Lawson Monet Totals $12,960 $10,480 $12,640 $ 51,120 19,692 2,604 8,204 -0- 17,341 -0- 70,430 5,208 6,510 $41,766 6,511 $25,195 6,511 $36,492 26,042 $152,800 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 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 = ($152,800 – $51,120 – $70,430 – B) B = ($31,250 – B) B = $6,250 – 2B 1.2 B = $6,250 B = $5,208 (or $2,604 per person) Capital Account Balances 1/1/11 – 12/31/11 Gray Stone Beginning balances $209,943 $164,102 Profit allocation (from above) 49,347 41,766 Drawings (10% of beginning balances) (20,994) (16,410) Ending balances $238,296 $189,458 Lawson $68,365 Monet $144,510 Totals $586,920 25,195 36,492 152,800 (6,837) $86,723 (14,451) $166,551 (58,692) $681,028 Lawson $90,000 -011,558 (9,000) $92,558 Totals $480,000 9,100 65,000 (48,000) $506,100 b GRAY, STONE, AND LAWSON Statement of Partners' Capital For Year Ending December 31, 2009 Beginning balances Added Investment Profit allocation Drawings Ending balances Gray $210,000 9,100 29,965 (21,000) $228,065 Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e Stone $180,000 -023,477 (18,000) $185,477 © The McGraw-Hill Companies, Inc., 2009 14-31 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 27 (40 Minutes) (Recording admission and retirement of partners using both the bonus and goodwill methods) a Porthos, Capital 35,000 D'Artagnan, Capital 35,000 (To reclassify half of Porthos's capital balance to reflect transfer of interest to D'Artagnan.) b Goodwill 50,000 Athos, Capital (50%) 25,000 Porthos, Capital (30%) 15,000 Aramis, Capital (20%) 10,000 (To record goodwill based on $250,000 implied value of partnership [$25,000/10%] Since current capital is only $200,000 [the $25,000 goes directly to the partners], goodwill of $50,000 has to be recorded and allocated using profit and loss ratio.) Athos, Capital (10% of balance) 10,500 Porthos, Capital (10% of balance) 8,500 Aramis, Capital (10% of balance) 6,000 D'Artagnan, Capital 25,000 (To reclassify 10% of each partner's capital to reflect transfer of interest to D'Artagnan.) c Cash 30,000 D'Artagnan, Capital (10% of total capital) 23,000 Athos, Capital (50% of excess payment) 3,500 Porthos, Capital (30% of excess payment) 2,100 Aramis, Capital (20% of excess payment) 1,400 (To record $30,000 payment by D'Artagnan which increases total capital to $230,000 D'Artagnan is credited for only 10% of that balance with the extra $7,000 payment being recorded as a bonus to the original partners.) d Cash 30,000 Goodwill 70,000 D'Artagnan, Capital 30,000 Athos, Capital (50% of goodwill) 35,000 Porthos, Capital (30% of goodwill) 21,000 Aramis, Capital (20% of goodwill) 14,000 (To record D'Artagnan's contribution to the partnership The $30,000 payment for 10% interest indicates a $300,000 value for the business although the capital balances would only increase to $230,000 The $70,000 difference is recorded as goodwill, an amount assigned to the original partners.) Irwin/McGraw-Hill 14-32 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 27 (continued) e Cash 12,222 Goodwill 10,000 D'Artagnan, Capital 22,222 To record investment by D'Artagnan The implied value of the investment as a whole would be only $122,220 ($12,222/10%) Since the capital balances are well in excess of this figure, D'Artagnan is apparently bringing some other factor (goodwill) into the partnership This goodwill can be computed as follows: $12,222 + Goodwill = 10% (Original Capital + $12,222 + Goodwill) $12,222 + Goodwill = 10% ($200,000 + $12,222 + Goodwill) $12,222 + Goodwill = $21,222 + 10 Goodwill 90 Goodwill = $9,000 Goodwill = $10,000 f Goodwill 80,000 Athos, Capital (50%) 40,000 Porthos, Capital (30%) 24,000 Aramis, Capital (20%) 16,000 (To record goodwill of $80,000 based on $280,000 appraisal of business.) Aramis, Capital 66,000 Cash 66,000 (To distribute cash to retiring partner based on final capital balance.) Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-33 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 28 (75 Minutes) (Recording of changes in the composition of a partnership including allocation of income) a 1/1/08 Building 52,000 Equipment 16,000 Cash 12,000 O'Donnell, Capital 40,000 Reese, Capital 40,000 (To record initial investment Assets recorded at fair value with two equal capital balances.) 12/31/08 Reese, Capital 22,000 O'Donnell, Capital 12,000 Income Summary 10,000 (The allocation plan specifies that O'Donnell will receive 20% in interest [or $8,000 based on $40,000 capital balance] plus $4,000 more [since that amount is greater than 15% of the profits from the period] The remaining $22,000 loss is assigned to Reese.) 1/1/09 Cash 15,000 O'Donnell, Capital (15%) 300 Reese, Capital (85%) 1,700 Dunn, Capital 17,000 (New investment by Dunn brings total capital to $85,000 after 2008 loss [$80,000 – $10,000 + $15,000] Dunn's 20% interest is $17,000 [$85,000 × 20%] with the extra $2,000 coming from the two original partners [allocated between them according to their profit and loss ratio].) 12/31/09 O'Donnell, Capital 10,340 Reese, Capital 5,000 Dunn, Capital 5,000 O'Donnell, Drawings 10,340 Reese, Drawings 5,000 Dunn, Drawings 5,000 (To close out drawings accounts for the year based on distributing 20% of each partner's beginning capital balances [after adjustment for Dunn's investment] or $5,000 whichever is greater O'Donnell's capital is $51,700 [$40,000 + $12,000 – $300]) 12/31/09 Income Summary 44,000 O'Donnell, Capital 16,940 Reese, Capital 16,236 Dunn, Capital 10,824 (To allocate $44,000 income figure for 2009 as determined below.) Irwin/McGraw-Hill 14-34 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 28 a (continued) O'Donnell Interest (20% of $51,700 beginning capital balance) 15% of $44,000 income 60:40 spilt of remaining $27,060 income Total Reese Dunn $16,236 $16,236 $10,824 $10,824 $10,340 6,600 $16,940 Capital Balances as of December 31, 2009: Initial 2008 investment 2008 profit allocation Dunn's investment 2009 drawings 2009 profit allocation 12/31/09 balances 1/1/10 O'Donnell $40,000 12,000 (300) (10,340) 16,940 $58,300 Reese $40,000 (22,000) (1,700) (5,000) 16,236 $27,536 Dunn, Capital Postner, Capital (To reclassify balance to reflect acquisition of Dunn's interest.) 22,824 12/31/10 O'Donnell, Capital Reese, Capital Postner, Capital O'Donnell, Drawings Reese, Drawings Postner, Drawings (To close out drawings accounts for the year based on 20% of beginning capital balances [above] or $5,000 [whichever is greater].) 11,660 5,507 5,000 Interest (20% of $58,300 beg capital) 15% of $61,000 income 60:40 split of remaining $40,190 Totals Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e $17,000 (5,000) 10,824 $22,824 22,824 11,660 5,507 5,000 12/31/10 Income Summary 61,000 O'Donnell, Capital Reese, Capital Postner, Capital (To allocate profit for 2010 determined as follows) O'Donnell $11,660 9,150 $20,810 Dunn 20,810 24,114 16,076 Reese Postner $24,114 $24,114 $16,076 $16,076 © The McGraw-Hill Companies, Inc., 2009 14-35 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 28 a (continued) 1/1/11 Postner, Capital O'Donnell, Capital (15%) Reese, Capital (85%) Cash (Postner's capital is $33,900 [$22,824 – $5,000 + $16,076] Extra 10% payment is deducted from the two remaining partners' capital accounts.) b 1/1/08 33,900 509 2,881 37,290 Building Equipment Cash Goodwill O'Donnell, Capital Reese, Capital (To record initial capital investments Reese is credited with goodwill of $80,000 to match O'Donnell's investment.) 52,000 16,000 12,000 80,000 12/31/08 Reese, Capital O'Donnell, Capital Income Summary (Interest of $16,000 is credited to O'Donnell [$80,000 × 20%] along with a base of $4,000 The remaining amount is now a $30,000 loss that is attributed entirely to Reese.) 30,000 1/1/09 15,000 22,500 Cash Goodwill Dunn, Capital (Cash and goodwill being contributed by Dunn are recorded Goodwill must be calculated algebraically.) 80,000 80,000 20,000 10,000 37,500 $15,000 + Goodwill = 20% (Current Capital + $15,000 + Goodwill) $15,000 + Goodwill = 20% ($150,000 + $15,000 + Goodwill) $15,000 + Goodwill = $33,000 + Goodwill Goodwill = $18,000 Goodwill = $22,500 Irwin/McGraw-Hill 14-36 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 28 b (continued) 12/31/09 O'Donnell, Capital 20,000 Reese, Capital 10,000 Dunn, Capital 7,500 O'Donnell, Drawings Reese, Drawings Dunn, Drawings (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.) 12/31/09 Income Summary 44,000 O'Donnell, Capital Reese, Capital Dunn, Capital (To allocate $44,000 income figure as follows) O'Donnell Interest (20% of $100,000 beginning capital balance) 15% of $44,000 income 60:40 split of remaining $17,400 Totals 26,600 10,440 6,960 Reese Dunn $10,440 $10,440 $6,960 $6,960 Reese $80,000 (30,000) Dunn $20,000 6,600 $26,600 Capital balances as of December 31, 2009: O'Donnell Initial 2008 investment $ 80,000 2008 profit allocation 20,000 Additional investment 2009 drawings (20,000) 2009 profit allocation 26,600 12/31/09 balances $106,600 1/1/10 20,000 10,000 7,500 (10,000) 10,440 $50,440 $37,500 (7,500) 6,960 $36,960 Goodwill 26,588 O'Donnell, Capital (15%) 3,988 Reese, Capital (51%) 13,560 Dunn, Capital (34%) 9,040 (To record goodwill indicated by purchase of Dunn's interest.) In effect, profits are shared 15% to O'Donnell, 51% to Reese – (60% of the 85% remaining after O'Donnell's income), and 34% to Dunn (40% of the 85% remaining after O'Donnell's income) Postner is paying $46,000, an amount $9,040 in excess of Dunn's capital ($36,960) The additional payment for this 34% income interest indicates total goodwill of $26,588 ($9,040/34%) Since Dunn is entitled to 34% of the profits but only holds 19% of the total capital, an Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-37 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 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 1/1/10 Dunn, Capital Postner, Capital (To reclassify capital balance to new partner.) 46,000 46,000 12/31/10 O'Donnell, Capital 22,118 Reese, Capital 12,800 Postner, Capital 9,200 O'Donnell, Drawings 22,118 Reese, Drawings 12,800 Postner, Drawings 9,200 (To close out drawings accounts for the year based on 20% of beginning capital balances [after adjustment for goodwill].) 12/31/10 Income Summary O'Donnell, Capital Reese, Capital Postner, Capital To allocate profit for 2010 as follows: 61,000 O'Donnell Reese Postner $17,839 $17,839 $11,893 $11,893 Reese $50,440 13,560 (12,800) 17,839 $69,039 Postner $36,960 9,040 (9,200) 11,893 $48,693 Interest (20% of $110,588 beginning capital balance) 15% of $61,000 income 60:40 spilt of remaining $29,732 Totals 31,268 17,839 11,893 $22,118 9,150 $31,268 Capital Balances as of December 31, 2010: 12/31/09 balances Adjustment for goodwill Drawings Profit allocation 12/31/10 balances O'Donnell $106,600 3,988 (22,118) 31,268 $119,738 Postner will be paid $53,562 (110% of the capital balance) for her interest This amount is $4,869 in excess of the capital account Since Postner is only entitled to a 34% share of profits and losses, the additional $4,869 must indicate that the partnership as a whole is undervalued by $14,321 (4,869/34%) Only in that circumstance would the extra payment to Postner be justified: Irwin/McGraw-Hill 14-38 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com 28 b (continued) 1/1/11 Goodwill O'Donnell, Capital (15%) Reese, Capital (51%) Postner, Capital (34%) (To recognize implied goodwill.) 14,321 1/1/11 Postner, Capital Cash (To record final distribution to Postner.) 53,562 Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e 2,148 7,304 4,869 53,562 © The McGraw-Hill Companies, Inc., 2009 14-39 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Develop Your Skills Research Case The article ―Partners At Risk‖ goes into an in-depth discussion of the potential losses that could be incurred by partners in a limited liability partnership (LLP) Some of the issues discussed in this article include the following: The issue of the security provided by an LLP has been raised recently by the Enron scandal and its role in the destruction of the international accounting firm Arthur Andersen (an LLP) The LLP was created so that a partner could protect personal assets despite the actions of other partners or the firm itself The legal validity of the LLP designation has never before been seriously challenged in court so the ultimate outcome of the Enron debacle as it relates to the partners of Arthur Andersen will provide legal guidance for years to come The LLP organization is an out-growth of the savings and loan scandals of the 1980s In some cases, wrongdoing was traced back to law firms and innocent partners suffered Texas was the first state (in 1991) to allow the LLP organization Now, however, virtually every state but Illinois allows the LLP in some form For law partnerships, the LLP has become more popular than either the professional corporation or the limited liability corporation The LLP organization, though, only becomes important in huge loss cases Normally a firm’s malpractice insurance and assets can cover all losses The Arthur Andersen situation has given the legal profession a chance to test the LLP structure Legal experts feel that the LLP will not be seriously damaged by the cases brought up in connection with Arthur Andersen and Enron 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 Probably the most noticeable characteristic of the statements for Buckeye Partners is that they resemble corporate financial statements in most ways A casual overview might not bring any differences to mind However, a close reading will show several differences including the following: On the income statement, net income is allocated between the general partner and limited partners Irwin/McGraw-Hill 14-40 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Also, on the income statement, earnings per share is replaced with a figure labeled as ―earnings per partnership unit.‖ The balance sheet does not present a stockholders’ equity section but rather partnership capital That section is comprised of just two figures: one for the general partner and the other for the limited partners The first two paragraphs of Note One to the financial statements describe the partnership organization A later paragraph presents a schedule reflecting the changes in partnership capital for both the general partner and the limited partners Analysis Case An unlimited number of allocation plans can be developed for any partnership Here, Wilson will be interested in some reward for investing the capital used to create the business Higgins will expect to be recognized for the work put into the operation Poncelet should seek some reward for any new clients that she is able to bring to the business 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 Higgins’s work in the day-to-day operations of the business so a large part of that remainder could be assigned to her As an alternative, Wilson could be allocated an interest factor but only based on the initial amount invested in the business rather than the capital balance as a whole Higgins could be assigned some type of allowance for the number of hours of work put in each period Any remaining income could be divided evenly among the three partners but only up to a certain level Beyond that, perhaps only Poncelet and Higgins would share in the income since they are doing the work, one in gaining new clients and the other in the day-to-day operations of the business Communication Cases and 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 Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-41 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com How big 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 the owners know and trust each other? As with the previous comment, potential liability can be greatly enhanced if the owners 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, President George W Bush has proposed the elimination of part or all of that tax Corporations become much more appealing if dividend income is not taxed How much money 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 Excel Case There are a number of different ways that a spreadsheet could be created to solve this particular problem Here is one possible approach: In Cell A1, enter label text ―Net Income‖ and in Cell B1 enter $200,000 In Cell A2, enter label text ―Billable Hours – Red‖ and in Cell B2 enter 2,000 In Cell C2, enter the hourly rate of $20 In Cell A3, enter label text ―Billable Hours – Blue‖ and in Cell B3 enter 1,500 In Cell C3, enter the hourly rate of $30 In Cell A4, enter label text ―Investment – Red‖ and in Cell B4 enter $80,000 In Cell C4, enter the rate of return of 10% Irwin/McGraw-Hill 14-42 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com In Cell A5, enter label text ―Investment – Blue‖ and in Cell B5 enter $50,000 In Cell C5, enter the rate of return of 10% Perform calculations: 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 partner’s 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 Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-43 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Determine the distribution of Profit between partners: 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 this spreadsheet has been created, any of the variables 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%) Irwin/McGraw-Hill 14-44 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual ... Inc., 2009 Solutions Manual Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Ending capital Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, ... hour worked Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com... other The major Irwin/McGraw-Hill Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e © The McGraw-Hill Companies, Inc., 2009 14-7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com