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 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.
—Bankruptcy. If the business should ever fail and have to be liquidated, losses of a partnership
are passed directly to the owners to reduce taxable income immediately. For a corporation, the loss is a capital loss to the stockholders which can only offset their own capital gains or be deducted at the rate of $3,000 per year. Thus, if a large loss is incurred, the tax benefits may not be realized for years into the future.
—Growth potential. Traditionally, corporations have more growth potential than do partnerships.
Ownership interests can be easily transferred. The limitation on liability encourages ownership by individuals who cannot participate in the management of the company. Partnerships are more restricted in adding new owners. Partnerships usually have to entice individuals who are willing to work in the business in order to obtain additional capital.
Therefore, the accountant may want to address the following questions in advising these
clients: � What amount of time and energy is involved in becoming incorporated? � How much profit or loss is anticipated from the operations of this business in the
foreseeable future? � How much debt will the new business incur? � Will this debt be guaranteed by the owners? � How much salary do the owners anticipate withdrawing from the business? � What are the chances of incurring lawsuits? � What is the possibility that the business will fail? � How large do the owners expect this business to grow? Do they anticipate the need
for new owners and new capital? � Does the creation of an S Corporation apply to this particular business?
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.
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.
Answers to Questions 1. The advantages of operating a business as a partnership include the ease of formation and
the avoidance of the double taxation effect that inherently reduces the profits distributed to the owners of a corporation. In addition, 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. 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.
4. 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 do 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.
5. In a general partnership, each partner can have unlimited liability for the debts of the
business. Therefore, a partner may face a significant risk, especially in connection with the actions and activities of other partners. However, general partnerships are easy to form and often serve well in smaller businesses where all partners know each other. The major advantage of a general partnership is that all income earned by the business is only taxed
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.
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:
a. Name and address of each partner b. Business location c. Description of the nature of the business d. Rights and responsibilities of each partner e. 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 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 partner’s 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:
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.
Answers to Problems 1. B 2. C 3. C Mary Ann's investment is equal to 1/3 of the total capital ($50,000/$150,000).
However, she is receiving a smaller capital balance, only a 1/4 interest. One explanation for this difference is that the business assets may be worth more than book value. To achieve agreement, the net assets could be valued upward to fair value with the adjustment recorded to the capital accounts of the original partners. As an alternative, a bonus could be credited to the original partners.
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.
Danville's investment = 30% (Original Capital Plus Danville's Investment)
$70,000 + Goodwill = .30 ($280,000 + $70,000 + Goodwill) $70,000 + Goodwill = $105,000 + .30 Goodwill .70 Goodwill = $35,000 Goodwill = $50,000 Danville's Investment (Capital) = $70,000 + $50,000 or $120,000 5. C The implied value of the company is $800,000 ($200,000/25%). Since the
current capital total is only $600,000, goodwill of $200,000 must be recognized. Oscar's investment is going to the partners so that it does not affect the capital total directly. Of the $200,000 in goodwill, 30 percent or $60,000 is attributed to Jethro which brings that capital balance to $260,000. Since a 25 percent interest is being conveyed to the new partner, Jethro's balance will then decrease by 25% or $65,000—a drop to $195,000.
6. B Total capital is $200,000 ($110,000 + $40,000 + $50,000) after the new
investment. As Kansas's portion is to be 30 percent, the capital balance would be $60,000 ($200,000 × 30%). Since only $50,000 was paid, a bonus of $10,000 must be taken from the two original partners based on their profit and loss ratio: Bolcar – $7,000 (70%) and Neary – $3,000 (30%). The reduction drops Neary's capital balance from $40,000 to $37,000.
7. B Total capital is $270,000 ($120,000 + $90,000 + $60,000) after the new investment. However, the implied value of the business based on the new investment is $300,000 ($60,000/20%). Thus, goodwill of $30,000 must be recognized with the offsetting allocation to the original partners based on their profit and loss ratio: Bishop – $18,000 (60%) and Cotton $12,000 (40%). The increase raises Cotton's capital from $90,000 to $102,000.
8. A Total capital is $450,000 ($210,000 + $140,000 + $100,000) after the new
investment. As Claudius's portion is to be 20 percent, the new capital balance would be $90,000 ($450,000 × 20%). Since $100,000 was paid, a bonus of $10,000 is being given to the two original partners based on their profit and loss ratio: Messalina – $6,000 (60%) and Romulus – $4,000 (40%). The increase raises Messalina's capital balance from $210,000 to $216,000 and Romulus's capital balance from $140,000 to $144,000.
9. D ASSIGNMENT OF INCOME—2007 ARTHUR BAXTER CARTWRIGHT TOTAL
Interest—10% 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 CAPITAL—2007 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 10. A ASSIGNMENT OF INCOME—YEAR ONE WINSTON DURHAM SALEM TOTAL
Interest—10% of beginning capital .............. $11,000 $ 8,000 $11,000 $30,000 Salary ....................................... 20,000 -0- 10,000 30,000 Allocation of remaining loss ($80,000 divided on a 5:2:3 basis) (40,000) (16,000) (24,000) (80,000) Totals ........................... $(9,000) $ (8,000) $ (3,000) $(20,000) STATEMENT OF CAPITAL—YEAR ONE WINSTON DURHAM SALEM TOTAL
Beginning capital ................... $110,000 $80,000 $110,000 $300,000 Net loss (above) ..................... (9,000) (8,000) (3,000) (20,000) Drawings (given) .................... (10,000) (10,000) (10,000) (30,000) Ending capital ................... $ 91,000 $62,000 $ 97,000 $250,000
10. (continued) ASSIGNMENT OF INCOME—YEAR TWO WINSTON DURHAM SALEM TOTAL
Interest—10% of beginning capital .............. $ 9,100 $ 6,200 $ 9,700 $25,000 Salary ....................................... 20,000 -0- 10,000 30,000 Allocation of remaining loss ($15,000 divided on a 5:2:3 basis) (7,500) (3,000) (4,500) (15,000) Totals ........................... $21,600 $3,200 $15,200 $ 40,000 STATEMENT OF CAPITAL—YEAR TWO WINSTON DURHAM SALEM TOTAL
Beginning capital (above) ..... $ 91,000 $62,000 $ 97,000 $250,000 Net income (above) ................ 21,600 3,200 15,200 40,000 Drawings (given) .................... (10,000) (10,000) (10,000) (30,000) Ending capital ................... $102,600 $55,200 $102,200 $260,000 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 partner’s capital balance from $30,000 to $24,000.
12. D Craig receives an additional $10,000. Since Craig is assigned 20 percent of
all profits and losses, this allocation indicates total goodwill of $50,000. 20% of Goodwill = $10,000 .20 G = $10,000 G = $10,000/.20 G = $50,000
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 Goodwill to Hamlet (7/10) .............................................. $ 7,000 Goodwill to MacBeth (3/10) ........................................... $ 3,000 Hamlet, capital (original balance plus goodwill) ......... $ 77,000 MacBeth, capital (original balance plus goodwill) ...... $ 43,000 Lear, capital (payment) (40% of total capital) .............. $ 80,000 b. Bonus Method Total capital after investment ($70,000 + 40,000 + $80,000) $190,000 Ownership portion—Lear .............................................. 40% Lear, capital .................................................................... $ 76,000 Bonus payment made by Lear ($80,000 – $76,000) ...... $ 4,000 Bonus to Hamlet (7/10) .................................................. $ 2,800 Bonus to MacBeth (3/10) ............................................... $ 1,200 Hamlet, capital (original balance plus bonus) ............. $ 72,800 MacBeth, capital (original balance plus bonus) .......... $ 41,200 Lear, capital (40% of total capital) ................................ $ 76,000
16. (15 Minutes) (Prepare journal entries to record admission of new partner under both the goodwill and the bonus methods)
Part a.
Total capital is $300,000 ($85,000 + $60,000 + $55,000 + $100,000) after the new investment. As Sergio's portion is 25 percent, this partner's capital balance would be $75,000. 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%).
Sergio, Capital ..................................................... 75,000 Tiger, Capital ....................................................... 12,500 Phil, Capital .......................................................... 7,500 Ernie, Capital ....................................................... 5,000
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%).
Tiger, Capital ............................................................. 2,500 Phil, Capital ............................................................... 1,500 Ernie, Capital ............................................................ 1,000 Sergio, Capital ..................................................... 65,000 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%).
Tiger, Capital ....................................................... 8,000 Phil, Capital .......................................................... 4,800 Ernie, Capital ....................................................... 3,200
Cash ........................................................................... 72,000 Sergio, Capital ..................................................... 72,000
17. (16 Minutes) (Determine capital balances after admission of new partner using both goodwill and bonus methods)
Part a.
Total capital is $490,000 ($200,000 + $120,000 + $90,000 + $80,000) after the new investment. However, the implied value of the business based on the new investment is only $444,444 ($80,000/18%). According to the goodwill method, this situation indicates that the new partner must be bringing some intangible attribute to the partnership other than just cash. This contribution must be computed algebraically and is recorded as goodwill to the new partner.
Goodwill = $10,000 The above goodwill balance indicates that Grant's total investment is $90,000 (cash of $80,000 and goodwill of $10,000). A $90,000 contribution raises the total capital to $500,000 so that Grant does, indeed, have an 18 percent interest ($90,000/$500,000).
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. Com Pack Hal Total Interest .................................. $17,640 $12,760 $7,600 $38,000 Remaining loss ..................... (1,000) (600) (400) (2,000) Income allocation ........... $16,640 $12,160 $7,200 $36,000 19. (5 Minutes) (Allocation of income to partners) Jones King Lane Total Bonus (20%) ......................... $18,000 $ -0- $ -0- $18,000 Interest (15% of average capital) 15,000 30,000 45,000 90,000 Remaining loss ($18,000) ... (6,000) (6,000) (6,000) (18,000) Income assignment ............. $27,000 $24,000 $39,000 $90,000
20. (15 Minutes) (Allocate income and determine capital balances) 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):
STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2009 Left Center Right Total Beginning balances ........... $20,000 $60,000 $50,000 $130,000 Income allocation .............. (5,280) (17,600) (7,120) (30,000) Drawings ............................. (10,000) (10,000) (10,000) (30,000) Ending balances ........... $ 4,720 $32,400 $32,880 $ 70,000
INCOME ALLOCATION—2010 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:
Left Center Right Total Interest (12% of beginning capital above)* ........................... $ 572 $ 3,611 $4,457 $ 8,640 Salary .................................. 12,000 8,000 -0- 20,000 Remaining income:
22. (12 Minutes) (Determine capital balances after retirement of a partner using both the goodwill and the bonus approaches)
a. Harrison receives an additional $30,000 about the capital balance. Since
Harrison is assigned 20 percent of all profits and losses, this extra allocation indicates total goodwill of $150,000, which must be split among all partners.
20% of Goodwill = $30,000 .20 G = $30,000 G = $150,000
CAPITAL BALANCES AFTER WITHDRAWAL
Original Balance Goodwill Withdrawal Final Balance
Lennon $230,000 $45,000 $275,000 McCartney 190,000 45,000 235,000 Harrison 160,000 30,000 $(190,000) -0- Starr 140,000 30,000 170,000 Total $680,000
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.
b. The drawings show the assets removed by a partner during a period of
time. A salary allowance is added to each partner's capital for the year (usually in recognition of work done) and is a component of net income allocation. The two numbers are often designed to be equal but agreement is not necessary. For example, a salary allowance might be high to recognize work contributed by one partner. The allowance increases the appropriate capital balance. The partner might, though, remove little or no money so that the partnership could maintain its liquidity.
c. Page, Drawings ......................................................... 5,000 Repair Expense ................................................... 5,000 (To reclassify payment made to repair personal residence.)
Page, Capital ............................................................. 13,000 Childers, Capital ....................................................... 11,000 Page, Drawings (adjusted) ................................. 13,000 Childers, Drawings .............................................. 11,000 (To close drawings accounts for 2008.)
Revenues ................................................................... 90,000 Expenses (adjusted by first entry) ..................... 59,000 Income Summary ................................................ 31,000 (To close revenue and expense accounts for 2008.) Income Summary ...................................................... 31,000 Page, Capital ........................................................ 11,000 Childers, Capital .................................................. 20,000 (To close net income to partners' capital–see allocation plan shown below.) Allocation of Income Page Childers
Interest (10% of beginning balance) $ 8,000 $ 3,000 Salary allowances 5,000 20,000 Remaining income (loss):
23. (continued) d. Total capital (original balances of $110,000 plus 2008 net income less drawings) ................................. $117,000
Investment by Smith ................................................. 43,000 Total capital after investment .................................. $160,000 Ownership portion acquired by Smith .................... 20% Smith, capital ............................................................ $ 32,000 Amount paid .............................................................. 43,000
Bonus paid by Smith—assigned to original partners $ 11,000
Bonus to Page (40%) ................................................ $4,400 Bonus to Childers (60%) .......................................... $6,600 Cash .......................................................................... 43,000
Smith, Capital (20% of total capital) .................. 32,000 Page, Capital ........................................................ 4,400 Childers, Capital .................................................. 6,600
24. (40 Minutes) (Reporting a change in the composition of a partnership) a. Exact amount of investment can only be computed algebraically:
E Investment = 25% (Original Capital + E Investment) El = .25 ($270,000 + El) El = $67,500 + .25 El .75 El = $67,500 E Investment = $90,000
b. Implied value of partnership ($36,000/10%) ............ $360,000 Total capital after investment by E ($270,000 + $36,000) 306,000 Goodwill .................................................................... $ 54,000 Allocation of Goodwill:
A (30%) ............................................................... $16,200 B (10%) ............................................................... 5,400 C (40%) ............................................................... 21,600 D (20%) ............................................................... 10,800
Total ................................................................ $54,000 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) d. Total capital after investment ($270,000 + $55,000) $325,000 Amount acquired by E .............................................. 20% E's capital balance ................................................... $ 65,000 E's payment ............................................................... 55,000 Bonus being given to E ............................................ $ 10,000 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 e. C's capital balance $ 90,000 C's collection (125%) 112,500 Bonus being paid to C $ 22,500 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
STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2008 Boswell Johnson Total Beginning Balances ($114,000 Invested capital split evenly— market value used for assets) $57,000 $57,000 $114,000 Income allocation (above) ... 9,200 1,800 11,000 Drawings ............................... -0- -0- -0- Ending balances ............. $66,200 $58,800 $125,000
WALPOLE INVESTMENT JANUARY 1, 2009 Walpole's $54,000 investment increases total capital to $179,000. Walpole is credited with a 40% interest or $71,600. According to the problem, the excess $17,600 is a bonus from the original partners. Of this amount, $10,560 is allocated from Johnson (60%) and $7,040 from Boswell (40%).
ALLOCATION OF INCOME—2009 Boswell Johnson Walpole Total Salary .................................... $12,000 $-0- $24,000 $36,000 Remaining $8,000 loss ($28,000 – $36,000) ........................... (960) (3,840) (3,200) (8,000) Totals ......................... $11,040 $(3,840) $20,800 $28,000
Pope's payment was made directly to the partners. Therefore, neither goodwill nor a bonus need be recognized. Instead, 10% of each capital balance shown above will be reclassified to Pope. The journal entry would be as follows:
Boswell, Capital ............................................................. 6,520 Johnson Capital ............................................................. 3,940 Walpole, Capital . ............................................................ 8,240 Pope, Capital ............................................................. 18,700
ALLOCATION OF INCOME—2010 Boswell Johnson Walpole Pope Total
26. (60 Minutes) (Allocate income and prepare a statement of partners' capital) a. Income Allocation—2009 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):
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.
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)
Capital Account Balances 1/1/11 – 12/31/11 Gray Stone Lawson Monet Totals Beginning balances $209,943 $164,102 $68,365 $144,510 $586,920 Profit allocation (from above) 49,347 41,766 25,195 36,492 152,800 Drawings (10% of beginning balances) (20,994) (16,410) (6,837) (14,451) (58,692) Ending balances $238,296 $189,458 $86,723 $166,551 $681,028 b.
GRAY, STONE, AND LAWSON Statement of Partners' Capital
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.)
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:
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.)
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.)
28. a. (continued) O'Donnell Reese Dunn Interest (20% of $51,700 beginning capital balance) ....... $10,340 15% of $44,000 income .................. 6,600 60:40 spilt of remaining $27,060 income ....................................... $16,236 $10,824 Total ................................................ $16,940 $16,236 $10,824 Capital Balances as of December 31, 2009: O'Donnell Reese Dunn Initial 2008 investment ................... $40,000 $40,000 2008 profit allocation ..................... 12,000 (22,000) Dunn's investment ......................... (300) (1,700) $17,000 2009 drawings ................................ (10,340) (5,000) (5,000) 2009 profit allocation ..................... 16,940 16,236 10,824 12/31/09 balances .......................... $58,300 $27,536 $22,824 1/1/10 Dunn, Capital ............................................ 22,824 Postner, Capital ................................... 22,824
(To reclassify balance to reflect acquisition of Dunn's interest.)
12/31/10 O'Donnell, Capital ..................................... 11,660 Reese, Capital ........................................... 5,507 Postner, Capital ........................................ 5,000 O'Donnell, Drawings ........................... 11,660 Reese, Drawings ................................. 5,507 Postner, Drawings .............................. 5,000
(To close out drawings accounts for the year based on 20% of beginning capital balances [above] or $5,000 [whichever is greater].)
12/31/10 Income Summary ....................................... 61,000 O'Donnell, Capital ............................... 20,810 Reese, Capital ..................................... 24,114 Postner, Capital ................................... 16,076 (To allocate profit for 2010 determined as follows) O'Donnell Reese Postner
Interest (20% of $58,300 beg. capital) $11,660 15% of $61,000 income ............ 9,150 60:40 split of remaining $40,190 ______ $24,114 $16,076 Totals ............................... $20,810 $24,114 $16,076
28. a. (continued) 1/1/11 Postner, Capital ........................................ 33,900 O'Donnell, Capital (15%) .......................... 509 Reese, Capital (85%) ................................ 2,881 Cash ..................................................... 37,290
(Postner's capital is $33,900 [$22,824 – $5,000 + $16,076]. Extra 10% payment is deducted from the two remaining partners' capital accounts.)
b. 1/1/08 Building ...................................................... 52,000 Equipment ................................................. 16,000 Cash ........................................................... 12,000 Goodwill .................................................... 80,000 O'Donnell, Capital ............................... 80,000 Reese, Capital ..................................... 80,000
(To record initial capital investments. Reese is credited with goodwill of $80,000 to match O'Donnell's investment.)
12/31/08 Reese, Capital ........................................... 30,000 O'Donnell, Capital ............................... 20,000 Income Summary ................................ 10,000
(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.)
28. b. (continued) 12/31/09 O'Donnell, Capital ..................................... 20,000 Reese, Capital ........................................... 10,000 Dunn, Capital ............................................ 7,500 O'Donnell, Drawings ............................ 20,000 Reese, Drawings ................................. 10,000 Dunn, Drawings ................................... 7,500
(To close out drawings accounts for the year based on 20 % of beginning capital balances: O'Donnell—$100,000, Reese—$50,000, and Dunn—$37,500.)
12/31/09 Income Summary ...................................... 44,000 O'Donnell, Capital ............................... 26,600 Reese, Capital ..................................... 10,440 Dunn, Capital ....................................... 6,960 (To allocate $44,000 income figure as follows) O'Donnell Reese Dunn
Interest (20% of $100,000 beginning capital balance) $20,000 15% of $44,000 income 6,600 60:40 split of remaining $17,400 $10,440 $6,960 Totals $26,600 $10,440 $6,960 Capital balances as of December 31, 2009: O'Donnell Reese Dunn Initial 2008 investment .. $ 80,000 $80,000 2008 profit allocation ..... 20,000 (30,000) Additional investment ... $37,500 2009 drawings ................ (20,000) (10,000) (7,500) 2009 profit allocation ..... 26,600 10,440 6,960 12/31/09 balances .......... $106,600 $50,440 $36,960
1/1/10 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
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 .................................................. 46,000 Postner, Capital ........................................ 46,000 (To reclassify capital balance to new partner.)
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 ........................................... 61,000 O'Donnell, Capital ..................................... 31,268 Reese, Capital ........................................... 17,839 Postner, Capital ........................................ 11,893 To allocate profit for 2010 as follows:
O'Donnell Reese Postner Interest (20% of $110,588 beginning capital balance) $22,118 15% of $61,000 income ....... 9,150 60:40 spilt of remaining $29,732 ............................ $17,839 $11,893 Totals ............................... $31,268 $17,839 $11,893
Capital Balances as of December 31, 2010: O'Donnell Reese Postner
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:
28. b. (continued) 1/1/11 Goodwill ............................................................... 14,321 O'Donnell, Capital (15%) ............................... 2,148 Reese, Capital (51%) ...................................... 7,304 Postner, Capital (34%) ................................... 4,869 (To recognize implied goodwill.)
1/1/11 Postner, Capital ................................................... 53,562 Cash ............................................................... 53,562 (To record final distribution to Postner.)
Develop Your Skills Research Case 1 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 2 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.
� 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 1 and 2 These two cases ask the student to identify the types of factors that will lend themselves toward the organization becoming a corporation (in Case 1) or a partnership (in Case 2). Several issues should be considered when looking into a legal format for a business enterprise:
� Do state laws play any role in the decision? In some states, particular types of organizations are prohibited from operating as a corporation. Will state law come into play in making this decision? If so, the partnership form of organization will be required.
� How big do the owners expect the company to become? If the business will remain small, there may be no need to raise additional capital so that the ability to sell ownership may not be an issue. This favors creation of a partnership. However, if Birmingham and Roberts expect the business to prosper and grow, they should consider which type of business will enable them to attract other capital or debt investments. Usually, it is a corporation that is best set up to enable growth through the issuance of securities.
� How risky is the business operation? If the company is operating in a business where liability is not a significant problem, the limited liability of a corporation might not be of much interest. However, if there is some risk involved, the two owners may need the corporate type of organization just for their own financial security.
� How well do the owners know and trust each other? As with the previous comment, potential liability can be greatly enhanced if the owners do not know each other well or if additional owners are expected to join at a later point in time. Under that circumstance, everyone may feel more comfortable if the business is created as a corporation or as one of the limited liability organizations. If the owners, though, are comfortable with each other, they may not feel the necessity of creating a formalized corporation.
� What changes will occur in the tax laws? At this writing, dividends paid by a corporation to its owners are taxable at 15%. However, 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 do they have available to create a legal organization? In most states, creation of a partnership can be virtually free whereas the legal formality of a corporation can cost money. If finances are tight, the business could begin as a partnership and then convert to a corporation at a later date as monetary restrictions ease.
Excel Case 1 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%.
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 ΣΣΣΣ 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.
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%).
