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Chapter 09 - Partnerships: Formation and Operation

CHAPTER 9
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.
1. 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.
2. 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. Partnership income allocation


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.

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Chapter 09 - Partnerships: Formation and Operation

1. The partners can simply assume an equal division of profits and losses.
2. 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.
1. 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.
2. 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 partners 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
1. 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.
2. 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.
3. As an alternative, all accounts can be adjusted to fair value with the amount of
payment being used as the basis for computing goodwill.

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Chapter 09 - Partnerships: Formation and Operation

Answers to Discussion Questions

What kind of business is this?

The owners of this business face a common problem: they began operations without seriously
considering the companys legal form. The accountant now needs to specify the advantages
and disadvantages of the partnership versus corporate or some other legal form. Eventually, the
owners must make this decision but should consider all relevant factors in 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 income allocation and partners contributions are already determined, the
document preparation should be relatively simple. Forming a corporation is a usually a more
difficult task depending on individual state laws. 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, any partner may be held liable for all business debts.
Thus, if liabilities escalate and the business fails, each partner risks a large possible loss.
The same problem does not exist in a corporation where owners and the business are
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 likely have less risk than a pharmaceutical company. The concept of
personal liability for business debts becomes especially important when litigation risk is high.
To reduce such risk, creating a corporation to protect the personal property of the
stockholders may be a wise move. The owners of a partnership may become personally
responsible for losses created by a business mistake or accident. The need for this
responsibility is recognized in states that prohibit doctors, lawyers, accountants, and the like
from incorporating. Such states, however, 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
Corporationa business that is incorporated but still taxed as a partnership.

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Chapter 09 - Partnerships: Formation and Operation

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.

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Chapter 09 - Partnerships: Formation and Operation

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.

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Chapter 09 - Partnerships: Formation and Operation

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, because 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

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Chapter 09 - Partnerships: Formation and Operation

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 partners liability is measured. In an LLP, the partners can still lose their
entire investment and be held responsible for all contractual debts of the business such as
loans. However, partners cannot be held responsible for damages caused by other partners.
For example, if one partner carelessly causes damage and is sued, the other partners are
not held responsible.

A limited liability company can now be created in certain situations. This type of organization
is classified as a partnership for tax purposes so that the double-taxation effect is avoided.
However, the liability of the owners is limited to their individual investments like a
Subchapter C Corporation. Depending on state law, the number of owners is not restricted
in the same manner as a Subchapter S Corporation so that there is a greater potential for
growth.

6. The Articles of Partnership is a legal agreement that should be created as a prerequisite for
the formation of a partnership. This document defines the rights and responsibilities of the
partners in relation to the business and in relation to each other. Thus, it serves as a
governing document for the partnership. The Articles of Partnership may contain any
number of provisions but should normally specify each of the following:

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 partners book value is retained.

8. In forming a partnership, one or more of the partners may be contributing some factor (such
as an established clientele or an expertise) which is not viewed normally as an asset in the
traditional accounting sense. In effect, the partner will be receiving a larger capital balance
than the identifiable contributions would warrant.

The bonus method of recording this transaction is to value and record only the identifiable
assets such as land and buildings. The capital accounts are then aligned to recognize the
proportionate interest being assigned to each partner's investment. If, for example, the
capital balances are to be equal, they are set at identical amounts that correspond in total to
the value of the identifiable assets.

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Chapter 09 - Partnerships: Formation and Operation

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 Because 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.
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Chapter 09 - Partnerships: Formation and Operation

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. Goodwill recognized in a capital transaction is allocated to the original partners 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.

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Chapter 09 - Partnerships: Formation and Operation

Answers to Problems

1. B

2. C

3. D

4. C Mary Ann's investment equals 1/3 of total capital ($50,000 $150,000).


However, she receives only a 1/4 interest capital balance. One explanation
for the difference is that the business assets are worth more than book
value. To achieve agreement, the net assets could be valued upward to fair
value with the adjustment credited to the original partners capital
accounts. Alternatively, a bonus could be credited to the original partners.

5. D Based on the new contribution, the companys implied value is $350,000


($105,000 30%) which is less than the capital balances ($315,000 in
original capital plus $105,000 to be invested). Thus, either the assets are
overvalued or the new partner is contributing goodwill in addition to a cash
investment. Because the problem indicates that goodwill is recognized,
goodwill must be computed. Note that the $105,000 is going into the
business and, thus, increases capital.

David's investment = 30% (Original capital plus David's investment)


$105,000 + Goodwill = .30 ($315,000 + $105,000 + Goodwill)
$105,000 + Goodwill = $126,000 + .30 Goodwill
.70 Goodwill = $21,000
Goodwill = $30,000
David's investment (Capital) = $105,000 + $30,000 = $135,000

6. B The implied value of the company is $960,000 ($240,000 25%). Because


the current capital total is only $760,000, goodwill of $200,000 must be
recognized. Krystal's investment is paid directly to the partners and does
not affect the capital total. Of the $200,000 in goodwill, 30 percent or
$60,000 is attributed to Dane which brings that capital balance to $340,000.
Because a 25% interest is conveyed to the new partner, Dane's balance
decreases by 25% or $85,000resulting in a new balance of $255,000.

7. B Total capital is $200,000 ($110,000 + $40,000 + $50,000) after the new


investment. As Kansas's portion is 30 percent, the capital balance becomes
$60,000 ($200,000 30%). Because only $50,000 was paid, a bonus of
$10,000 is taken from the two original partners based on their profit and
loss ratios: Bolcar $7,000 (70%) and Neary $3,000 (30%). The reduction
drops Neary's capital balance from $40,000 to $37,000.

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Chapter 09 - Partnerships: Formation and Operation

8. 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.

9. A Total capital is $450,000 ($210,000 + $140,000 + $100,000) after the new


investment. As Claudius' portion is to be 20 percent, the new capital
balance would be $90,000 ($450,000 20%). Because $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.

10. D ASSIGNMENT OF INCOME


ALFRED BERNARD COLLINS TOTAL
Interest5% of
beginning capital ................. $ 2,500 $ 3,000 $ 3,500 $ 9,000
Salary........................................ 18,000 18,000
Allocation of remaining income
($33,000 divided on a 3:3:4 basis) 9,900 9,900 13,200 33,000
Totals ............................. $12,400 $30,900 $16,700 $60,000

STATEMENT OF CAPITAL
ALFRED BERNARD COLLINS TOTAL
Beginning capital .................... $50,000 $60,000 $70,000 $180,000
Net income (above) ................. 12,400 30,900 16,700 60,000
Drawings (given) ..................... (5,000) (5,000) (5,000) (15,000)
Ending capital ......................... $57,400 $85,900 $81,700 $225,000

11. A ASSIGNMENT OF INCOMEYEAR ONE


WINSTON DURHAM SALEM TOTAL
Interest10% 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 CAPITALYEAR 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

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Chapter 09 - Partnerships: Formation and Operation

11. (continued)

ASSIGNMENT OF INCOMEYEAR TWO


WINSTON DURHAM SALEM TOTAL
Interest10% 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 CAPITALYEAR 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

12. A Costello receives a $10,000 bonus ($100,000 less $90,000 capital balance).
This bonus is deducted from the two remaining partners according to their
profit and loss ratio (2:3). A 60 percent (3/5) reduction is assigned to Burns
which decreases that partners capital balance from $30,000 to $24,000.

13. D Clark receives an additional $10,000. Because Clark receives 20 percent of


profits and losses, this allocation indicates total goodwill of $50,000.
20% of Goodwill = $10,000
Goodwill = $10,000 .20 = $50,000

Goodwill 50,000
Manning, capital (30%) 15,000
Gonzalez, capital (30%) 15,000
Clark, capital (20%) 10,000
Freeney, capital (20%) 10,000

The above entry raises Mannings capital from $130,000 to $145,000.

14. B Under the bonus method, Clarks excess payment is deducted from the
remaining partners capital accounts according to their relative profit and loss
ratios, 3:3:2. Mannings balance is then $126,250 = $130,000 $3,750.

Manning, capital 3,750


Gonzalez, capital 3,750
Freeney, capital 2,500
Clark, capital 80,000
Cash 90,000

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Chapter 09 - Partnerships: Formation and Operation

15. A The implied value of the company is $900,000 ($270,000 30%). Because
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 is 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.

16. D Because 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.

17. (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 portionLear ................................................ 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

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Hill Education.
Chapter 09 - Partnerships: Formation and Operation

18. (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. Because $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%).

Cash ............................................................................ 100,000


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 25 percent, this partner's capital
balance is $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%).

Cash ............................................................................ 60,000


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%).

Goodwill ..................................................................... 16,000


Tiger, capital .......................................................... 8,000
Phil, capital ............................................................ 4,800
Ernie, capital .......................................................... 3,200
Cash ............................................................................. 72,000
Sergio, capital ....................................................... 72,000

9-14
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Hill Education.
Chapter 09 - Partnerships: Formation and Operation

19. (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.

G's Investment = .18 ($200,000 + $120,000 + $90,000 + G's Investment)


$80,000 + Goodwill = .18 ($410,000 + $80,000 + Goodwill)
$80,000 + Goodwill = $88,200 + .18 Goodwill
.82 Goodwill = $8,200
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. Because 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

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Chapter 09 - Partnerships: Formation and Operation

20. (10 Minutes) (Record admission of new partner and allocation of new income)

Part a.

Total capital is $167,000 ($70,000 + $60,000 + $37,000) after the new


investment. However, the implied value of the business based on the new
investment is $185,000 ($37,000 20%). Consequently, goodwill of $18,000
must be recognized with the offsetting allocation to the original two
partners based on their profit and loss ratio: Prince$14,400 (80%) and
Robbins$3,600 (20%).

Goodwill.................................................................. 18,000
Prince, capital .................................................. 14,400
Robbins, capital ............................................... 3,600
Cash ...................................................................... 37,000
Jeffrey, capital .................................................. 37,000

Part b.
Prince Robbins Jeffrey Total
Interest .................................. $8,440 $6,360 $3,700 $18,500
Remaining loss...................... (1,750) (1,050) (700) (3,500)
Income allocation ........... $6,690 $5,310 $3,000 $15,000

21. (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

9-16
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Hill Education.
Chapter 09 - Partnerships: Formation and Operation

22. (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):
$ 23,600
(12,600)
(51,000)
$(40,000) (16,000) (8,000) (16,000) (40,000)

Totals $ 8,600 $21,000 $(6,000) $23,600

CALCULATION OF PURKERSON'S INTEREST ALLOCATION

Balance, January 1April 1 ($60,000 3) $180,000


Balance, April 1December 31 ($68,000 9) 612,000
Total ................................................................................... $792,000
Months............................................................................... 12
Average monthly capital balance ................................... $ 66,000
Interest rate ...................................................................... 10%
Interest allocation (above) .............................................. $ 6,600

STATEMENT OF PARTNERS' CAPITAL


Purkerson Smith Traynor Totals
Beginning balances ............... $60,000 $40,000 $20,000 $120,000
Additional contribution ......... 8,000 -0- -0- 8,000
Income (above) ...................... 8,600 21,000 (6,000) 23,600
Drawings ($1,000 per month) (12,000) (12,000) (12,000) (36,000)
Ending capital balances......... $64,600 $49,000 $ 2,000 $115,600

9-17
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Chapter 09 - Partnerships: Formation and Operation

23. (30 Minutes) (Allocate income for several years and determine ending capital
balances)

INCOME ALLOCATION2014

Left Center Right Total


Interest (12% of beginning capital) $2,400 $ 7,200 $ 6,000 $ 15,600
Salary 12,000 8,000 -0- 20,000
Remaining income/loss:
$(30,000)
(15,600)
(20,000)
$(65,600) (19,680) (32,800) (13,120) (65,600)
Totals $(5,280) $(17,600) $(7,120) $(30,000)

STATEMENT OF PARTNERS' CAPITALDECEMBER 31, 2014

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 ALLOCATION2015
Left Center Right Total
Interest(12% of beginning capital above) *$566 $3,888 $3,946 $ 8,400
Salary .................................. 12,000 8,000 -0- 20,000
Remaining income/loss:
$20,000
(8,400)
(20,000)
$(8,400) (2,520) (4,200) (1,680) (8,400)
Totals................... $10,046 $7,688 $2,266 $20,000
*Rounded

STATEMENT OF PARTNERS' CAPITALDECEMBER 31, 2015

Left Center Right Total


Beginning balances (above) $ 4,720 $32,400 $32,880 $70,000
Additional investment ........ -0- -0- 12,000 12,000
Income allocation ................ 10,046 7,688 2,266 20,000
Drawings .............................. (10,000) (10,000) (10,000) (30,000)
Ending balances ............ $ 4,766 $30,088 $37,146 $72,000

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Chapter 09 - Partnerships: Formation and Operation

23. (continued)
INCOME ALLOCATION2016
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:
$40,000
(8,640)
(20,000)
$11,360......................... 2,272 4,544 4,544 11,360
Totals.......................... $14,844 $16,155 $9,001 $40,000

*Rounded

STATEMENT OF PARTNERS' CAPITALDECEMBER 31, 2016


Left Center Right Total
Beginning balances (above) $ 4,766 $30,088 $37,146 $72,000
Income allocation 14,844 16,155 9,001 40,000
Drawings (10,000) (10,000) (10,000) (30,000)
Ending balances $ 9,610 $36,243 $36,147 $82,000

9-19
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Hill Education.
Chapter 09 - Partnerships: Formation and Operation

24. (12 Minutes) (Determine capital balances after retirement of a partner using
both the goodwill and the bonus approaches)

a. Fergie receives $30,000 more than her capital balance. Because Fergie 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
Pineda $230,000 $45,000 $275,000
Adams 190,000 45,000 235,000
Fergie 160,000 30,000 $(190,000) -0-
Gomez 140,000 30,000 170,000
Total $680,000

b. A $50,000 bonus is paid to Pineda ($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 Adams 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 Fergie 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 Gomez or a decrease of $8,333 which drops this
partner's capital balance from $140,000 to $131,667.

25. (10 minutes) (Hybrid method for recording a partner withdrawal)

Because the continuing partners do not wish to record goodwill, a hybrid approach
records identifiable asset fair value changes and corresponding capital
adjustments, but no goodwill. The remaining excess payment to the withdrawing
partner after the revaluation is then treated as a bonus.

Building 40,000
Matteson, capital 12,000
Richton, capital 20,000
OToole, capital 8,000

OToole, capital 108,000


Matteson, capital 4,500
Richton, capital 7,500
Cash 120,000

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Chapter 09 - Partnerships: Formation and Operation

26. (45 Minutes) (P&L allocations and admission of a new partner)

a. The interest factor was probably inserted to reward Hugh for contributing
$50,000 more to the partnership than Jacobs. The salary allowance gives
an additional $20,000 to Jacobs 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. Hugh, drawings .......................................................... 7,500


Repair expense ..................................................... 7,500
(To reclassify payment made to repair personal residence.)
Hugh, capital ............................................................... 16,500
Jacobs, capital ............................................................ 14,000
Hugh, drawings (adjusted for home repairs) ..... 16,500
Jacobs, drawings .................................................. 14,000
(To close drawings accounts for 2014.)
Revenues ..................................................................... 175,000
Expenses (adjusted by first entry) ...................... 138,500
Income summary .................................................. 36,500
(To close revenue and expense accounts for 2014.)

Income summary ........................................................ 36,500


Hugh, capital ......................................................... 12,600
Jacobs, capital ...................................................... 23,900
(To close net income to partners' capitalsee allocation plan shown below.)

Allocation of Income Hugh Jacobs


Interest (10% of beginning balance) $ 15,000 $ 10,000
Salary allowances 5,000 25,000
Remaining income (loss):
Net income $ 36,500
Interest (25,000)
Salary (30,000)
Remainder $ (18,500) (7,400) (40%) (11,100) (60%)
Profit allocation $12,600 $23,900

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Chapter 09 - Partnerships: Formation and Operation

26. (continued)

d. Total capital (original balances of $250,000 plus 2014


net income less drawings) ................................... $256,000
Investment by Thomas .............................................. 64,000
Total capital after investment .................................... $320,000
Ownership portion acquired by Thomas ................. 15%
Thomas, capital .......................................................... $ 48,000
Amount paid ................................................................ 64,000
Bonus paid by Thomasassigned to original partners $ 16,000

Bonus to Hugh (40%) ................................................. $6,400

Bonus to Jacobs (60%) .............................................. $9,600

Cash ............................................................................ 64,000


Thomas, capital (20% of total capital) ................ 48,000
Hugh, capital ......................................................... 6,400
Jacobs, capital ...................................................... 9,600

9-22
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Hill Education.
Chapter 09 - Partnerships: Formation and Operation

27. (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. Because 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 Investment = 20% (Original Capital + E Investment)


$42,000 + Goodwill = .20 ($270,000 + $42,000 + Goodwill)
$42,000 + Goodwill = $62,400 + .20 Goodwill
.80 Goodwill = $20,400
Goodwill = $25,500

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).

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Chapter 09 - Partnerships: Formation and Operation

27. (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

9-24
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Hill Education.
Chapter 09 - Partnerships: Formation and Operation

28. (55 Minutes) (Allocation of income to the partners and determination of capital
balances)

ALLOCATION OF INCOME2013
Boswell Johnson Total
Salary (8 months) ................. $8,000 $-0- $ 8,000
Remaining $3,000 ................. 1,200 (40%)
3,000
Totals ................................ $9,200 $1,800 $11,000

STATEMENT OF PARTNERS' CAPITALDECEMBER 31, 2013


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, 2014


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 INCOME2014

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

STATEMENT OF PARTNERS' CAPITALDECEMBER 31, 2014

Boswell Johnson Walpole Total


Beginning balances ............. $66,200 $58,800 $ -0- $125,000
Walpole's contribution ......... (7,040) (10,560) 71,600 54,000
Income allocation (above) ... 11,040 (3,840) 20,800 28,000
Drawings ............................... (5,000) (5,000) (10,000) (20,000)
Ending balances ............. $65,200 $39,400 $82,400 $187,000

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Chapter 09 - Partnerships: Formation and Operation

28. (continued)
ADMISSION OF POPEJANUARY 1, 2015
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 INCOME2015

Boswell Johnson Walpole Pope Total


Salary $12,000 $-0- $24,000 $9,600 $45,600
Remaining $400 income 54 162 144 40 400
Totals $12,054 $162 $24,144 $9,640 $46,000

STATEMENT OF PARTNERSHIP CAPITALDECEMBER 31, 2015

Boswell Johnson Walpole Pope Total


Beginning balances $65,200 $39,400 $82,400 $-0- $187,000
Admission of Pope (6,520) (3,940) (8,240) 18,700 -0-
Allocation of income
(above) 12,054 162 24,144 9,640 46,000
Drawings (5,000) (5,000) (10,000) (4,000) (24,000)
Ending balances $65,734 $30,622 $88,304 $24,340 $209,000

9-26
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Hill Education.
Chapter 09 - Partnerships: Formation and Operation

29. (60 Minutes) (Allocate income and prepare a statement of partners' capital)

a. Income Allocation2013
Gray Stone Lawson Totals
Salary allowance ($8 per billable
hour) $13,680 $11,520 $10,400 $35,600
Interest (see Note A) 25,928 21,600 10,800 58,328
Bonus (not applicable because
salary and interest would
necessitate a negative bonus) -0- -0- -0- -0-
Remaining loss (split evenly):
$ 65,000
(35,600)
(58,328)
$(28,928) (9,643) (9,643) (9,642) (28,928)
Profit allocation $29,965 $23,477 $11,558 $65,000

Note A: Interest for Stone and Lawson is calculated at 12% of their beginning
capital balances ($180,000 and $90,000, respectively) while for Gray the
computation is based on a $210,000 balance for 4/12 of the year and $219,100
for the remaining 8/12.

Capital Account Balances1/1/13 12/31/13

Gray Stone Lawson Totals


Beginning contributions $210,000 $180,000 $90,000 $480,000
Added Investment 9,100 -0- -0- 9,100
Profit allocation (from above) 29,965 23,477 11,558 65,000
Drawing (10% of beginning
balances) (21,000) (18,000) (9,000) (48,000)
Ending balances $228,065 $185,477 $92,558 $506,100

Prior to developing the information for 2014, a computation of Monet's


investment must be made:

Monet's Investment = 25% ($506,100 + Monet's Investment)


Ml = $126,525 + .25 Ml
.75 Ml = $126,525
Ml = $168,700

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Chapter 09 - Partnerships: Formation and Operation

29. a. (continued)
Income Allocation2014
Gray Stone Lawson Monet Totals
Salary allowance ($8
per billable hour) $14,400 $ 12,000 $ 11,040 $ 9,520 $ 46,960
Interest (12% of begin-
ning capital balances
for the year) 27,368 22,257 11,107 20,244 80,976
Bonus (not applicable) -0- -0- -0- -0- -0-
Remaining loss (split
evenly):
$ (20,400)
(46,960)
(80,976)
$(148,336) (37,084) (37,084) (37,084) (37,084) (148,336)
Loss allocation $ 4,684 $(2,827) $(14,937) $ (7,320) $(20,400)

Capital Account Balances 1/1/14 12/31/14


Gray Stone Lawson Monet Totals
Beginning balances $228,065 $185,477 $92,558 $168,700 $674,800
Loss allocation (from
above) 4,684 (2,827) (14,937) (7,320) (20,400)
Drawings (10% of
beginning
balances) (22,806) (18,548) (9,256) (16,870) (67,480)
Ending balances $209,943 $164,102 $68,365 $144,510 $586,920

Income Allocation2015
Gray Stone Lawson Monet Totals
Salary allowance ($8
per billable hour) $15,040 $12,960 $10,480 $12,640 $ 51,120
Interest (12% of
beginning capital
balances for the
year) 25,193 19,692 8,204 17,341 70,430
Bonus (see Note B) 2,604 2,604 -0- -0- 5,208
Remaining profit split
evenly:
$152,800
(51,120)
(70,430)
(5,208)
$ 26,042 6,510 6,510 6,511 6,511 26,042
Profit allocation $49,347 $41,766 $25,195 $36,492 $152,800

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Chapter 09 - Partnerships: Formation and Operation

29. a. (continued)

Note B: The bonus to Gray and Stone can only be derived algebraically.
Because 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 1/1/15 12/31/15

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, LAWSON, and MONET
Statement of Partners' Capital
For Year Ending December 31, 2015

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

9-29
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Chapter 09 - Partnerships: Formation and Operation

30. (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 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%]. Because 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.)

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Chapter 09 - Partnerships: Formation and Operation

30. (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%). Because 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.)

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Chapter 09 - Partnerships: Formation and Operation

31. (75 Minutes) (Recording of changes in the composition of a partnership


including allocation of income)

a. 1/1/13 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.)

12/31/13 Reese, capital ............................................. 22,000


O'Donnell, capital ................................. 12,000
Income summary .................................. 10,000
(The allocation plan specifies that O'Donnell receives 20% in
interest [or $8,000 based on $40,000 capital balance] plus $4,000
more [Because that amount exceeds 15% of the profits from the
period]. The remaining $22,000 loss is assigned to Reese.)

1/1/14 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 2013
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].)

12/31/14 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])

12/31/14 Income summary ....................................... 44,000


O'Donnell, capital ................................. 16,940
Reese, capital ........................................ 16,236
Dunn, capital ......................................... 10,824
(To allocate $44,000 income figure for 2014 as determined below.)

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Chapter 09 - Partnerships: Formation and Operation

31. 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 split of remaining $27,060
income ........................................ $16,236 $10,824
Total .................................................. $16,940 $16,236 $10,824

Capital Balances as of December 31, 2014:


O'Donnell Reese Dunn
Initial 2013 investment .................... $40,000 $40,000
2013 profit allocation ...................... 12,000 (22,000)
Dunn's investment .......................... (300) (1,700) $17,000
2014 drawings ................................. (10,340) (5,000) (5,000)
2014 profit allocation ...................... 16,940 16,236 10,824
12/31/14 balances ............................ $58,300 $27,536 $22,824

1/1/15 Dunn, capital ............................................... 22,824


Postner, capital ..................................... 22,824
(To reclassify balance to reflect
acquisition of Dunn's interest.)

12/31/15 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].)

12/31/15 Income summary......................................... 61,000


O'Donnell, capital ................................. 20,810
Reese, capital ........................................ 24,114
Postner, capital ..................................... 16,076
(To allocate profit for 2015 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

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Chapter 09 - Partnerships: Formation and Operation

31. a. (continued)
1/1/16 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. 1/1/13 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.)

12/31/13 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.)

1/1/14 Cash ............................................................. 15,000


Goodwill ...................................................... 22,500
Dunn, capital ......................................... 37,500
(Cash and goodwill being contributed by
Dunn are recorded. Goodwill must be
calculated algebraically.)

$15,000 + Goodwill = 20% (Current Capital + $15,000 + Goodwill)


$15,000 + Goodwill = 20% ($150,000 + $15,000 + Goodwill)
$15,000 + Goodwill = $33,000 + .2 Goodwill
.8 Goodwill = $18,000
Goodwill = $22,500

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Chapter 09 - Partnerships: Formation and Operation

31. b. (continued)
12/31/14 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.)
12/31/14 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, 2014:


O'Donnell Reese Dunn
Initial 2013 investment . . . $ 80,000 $80,000
2013 profit allocation ...... 20,000 (30,000)
Additional investment .... $37,500
2014 drawings ................. (20,000) (10,000) (7,500)
2014 profit allocation ...... 26,600 10,440 6,960
12/31/14 balances ........... $106,600 $50,440 $36,960
1/1/15 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%).
Because Dunn is entitled to 34% of the profits but only holds 19% of the total
capital, an 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.
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Chapter 09 - Partnerships: Formation and Operation

31. b. (continued)

1/1/15 Dunn, capital .................................................... 46,000


Postner, capital ........................................... 46,000
(To reclassify capital balance to new partner.)
12/31/15 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].)
12/31/15 Income summary ............................................. 61,000
O'Donnell, capital ....................................... 31,268
Reese, capital ............................................. 17,839
Postner, capital ........................................... 11,893
To allocate profit for 2015 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 split of remaining
$29,732 ............................. $17,839 $11,893
Totals ................................ $31,268 $17,839 $11,893
Capital Balances as of December 31, 2015:
O'Donnell Reese Postner
12/31/14 balances ................. $106,600 $50,440 $36,960
Adjustment for goodwill ...... 3,988 13,560 9,040
Drawings................................ (22,118) (12,800) (9,200)
Profit allocation..................... 31,268 17,839 11,893
12/31/15 balances.................. $119,738 $69,039 $48,693

Postner will be paid $53,562 (110% of the capital balance) for her interest. This
amount exceeds her capital balance by $4,869. Because Postner is only
entitled to a 34% share of profits and losses, the additional $4,869 indicates
that the partnership as a whole is undervalued by $14,321 (4,869 34%). Only
in that circumstance is the extra payment to Postner justified:

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Chapter 09 - Partnerships: Formation and Operation

31. b. (continued)

1/1/16 Goodwill ................................................................. 14,321


O'Donnell, capital (15%) .................................. 2,148
Reese, capital (51%) ........................................ 7,304
Postner, capital (34%) ..................................... 4,869
(To recognize implied goodwill.)
1/1/16 Postner, capital ..................................................... 53,562
Cash ................................................................. 53,562
(To record final distribution to Postner.)

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Chapter 09 - Partnerships: Formation and Operation

Develop Your Skills

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.
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 Higginss 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 Because they are doing the

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Chapter 09 - Partnerships: Formation and Operation

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, from time to time
various politicians have proposed the elimination of part or all of that tax.
Corporations gain appeal 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.

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Chapter 09 - Partnerships: Formation and Operation

Excel Case: There are a variety of ways to create a spreadsheet to solve this particular problem.
Here is one possible approach:

In Cell A1, enter text Net Income and in Cell B1 enter $200,000.
In Cell A2, enter text Billable HoursRed. In Cell B2 enter 2,000. In Cell C2, enter $20 hourly rate.
In Cell A3, enter text Billable HoursBlue. In Cell B3 enter 1,500. In Cell C3, enter $30 hourly rate.
In Cell A4, enter text InvestmentRed and in Cell B4 enter $80,000. In Cell C4, enter the rate of
return of 10%.
In Cell A5, enter text InvestmentBlue and in Cell B5 enter $50,000. In Cell C5, enter the rate of
return of 10%.

Perform calculation: 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 partners 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 the spreadsheet is created, any variable 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%).

Example:

Net Income $200,000


Billable Hours-Red 2,000 $20 $40,000
Billable Hours-Blue 1,500 $30 45,000
Investment-Red $80,000 10% 8,000
Investment-Blue $50,000 10% 5,000
Subtotal $98,000

Profit to be Split: $102,000

Profit-Red 50% $51,000


Profit-Blue 50% $51,000

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Chapter 09 - Partnerships: Formation and Operation

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