Division of Net Income or Loss

The following examples show how each of the methods of dividing net income or loss may be applied.
This series of illustrations is based on data for Alb & Bay LLP, which had a net income of $300,000 for
the year ended December 31, 2005, the first fiscal year of operations. The partnership contract provides
that each partner may withdraw $5,000 cash on the last day of each month; both partners did so during
2005. The drawings are recorded by debits to the partners’ drawing accounts and are not a factor in the
division of net income or loss; all other withdrawals, investments, and net income or loss are entered
directly in the partners’ capital accounts. Partner Alb invested $400,000 on January 1, 2005, and an
additional $100,000 on April 1. Partner Bay invested $800,000 on January 1, 2005, and withdrew $50,000
on July 1. These transactions and events are summarized in the following Capital, Drawing, and Income
Summary ledger accounts
Alb, Capital
1.1.2005 $400,000
1.4.2005 100,000

Bay, Capital
1.7.2005 $50,000 1.1.2005 $800,000

Alb, Drawing
Jan-Dec. $60,000

Bay, Drawing

Jan-Dec. $60,000

Income Summary
31.12.2005 $300,000
Division of Earnings Equally or in Some Other Ratio
Many limited liability partnership contracts provide that net income or loss is to be divided equally. Also, if the
partners have made no specific agreement for income sharing, the Uniform Partnership Act provides that an intent of
equal division is assumed. The net income of $300,000 for Alb & Bay LLP is transferred by a closing entry on
December 31, 2005, from the Income Summary ledger account to the partners’ capital accounts by the following
journal entry:

Income Summary 300,000

Alb, Capital 150,000
Bay, Capital 150,000
To record division of net income for 2005.
The drawing accounts are closed to the partners’ capital accounts on December 31,
2005, as follows:
Alb, Capital 60,000
Bay, Capital 60,000
Alb, Drawing 60,000
Bay, Drawing 60,000
To close drawing accounts.
After the drawing accounts are closed, the balances of the partners’ capital accounts
show the ownership equity of each partner on December 31, 2005.

If Alb & Bay LLP had a net loss of, say, $200,000 during the year ended December 31,
2005, the Income Summary ledger account would have a debit balance of $200,000. This
loss would be transferred to the partners’ capital accounts by a debit to each capital account
for $100,000 and a credit to the Income Summary account for $200,000.
The journal entry:
Alb, Capital 100,000
Bay, Capital 100,000
Income summary 200,000

If Alb and Bay share earnings in the ratio of 60% to Alb and 40% to Bay and net income
was $300,000, the net income would be divided $180,000 to Alb and $120,000 to Bay. The
agreement that Alb should receive 60% of the net income (perhaps because of greater
experience and personal contacts) would cause Partner Alb to absorb a larger share of the
net loss if the partnership operated unprofitably.
The journal entry is:

Income Summary 300,000

Alb, Capital 180,000 (60%*300,000)
Bay, Capital 120,000 (40%*300,000)
Some partnership contracts provide that a net income is to be divided in a specified ratio, such as 60% to
Alb and 40% to Bay, but that net loss is divided equally or in some other ratio. Another variation intended
to compensate for unequal contributions by the partners provides that an agreed ratio (60% and 40% in
this example) shall be applicable to a specified amount of income but that any additional income shall be
shared in some other ratio.
Division of Earnings in Ratio of Partners’ Capital Account Balances
Division of partnership earnings in proportion to the capital invested by each partner is most likely to be found in
limited liability partnerships in which substantial investment is the principal ingredient for success. To avoid
controversy, it is essential that the partnership contract specify whether the income-sharing ratio is based on:

(1) the original capital investments.

(2) the capital account balances at the beginning of each year.

(3) the balances at the end of each year (before the division of net income or loss).

(4) the average balances during each year.

Continuing the illustration for Alb & Bay LLP, assume that the partnership contract provides for division of net
income in the ratio of original capital investments. The net income of $300,000 for 2005 is divided as follows:
Alb: $300,000 * $400,000/$1,200,000 = $100,000
Bay: $300,000 * $800,000/$1,200,000 = $200,000

journal entry is:

Income Summary 300,000
Alb, Capital 100,000
Bay, Capital 200,000
To record division of net income for 2005.

Assuming that the net income is divided in the ratio of capital account balances at the end of the year
(before drawings and the division of net income), the net income of $300,000 for 2005 is divided as
follows:
Alb: $300,000 * $500,000/$1,250,000 = $120,000
Bay: $300,000 * $750,000/$1,250,000 = $180,000
The journal entry is:
Income Summary 300,000
Alb, Capital 120,000
Bay, Capital 180,000
Division of net income on the basis of (1) original capital investments, (2) yearly beginning capital
account balances, or (3) yearly ending capital account balances may prove inequitable if there are material
changes in capital accounts during the year. Use of average balances as a basis for sharing net income is
preferable because it reflects the capital actually available for use by the partnership during the year.
If the partnership contract provides for sharing net income in the ratio of average capital account balances
during the year, it also should state the amount of drawings each partner may make without affecting the
capital account.

In the example for Alb & Bay LLP, the partners are entitled to withdraw $5,000 cash monthly. Any
additional withdrawals or investments are entered directly in the partners’ capital accounts and therefore
influence the computation of the average capital ratio. The partnership contract also should state whether
capital account balances are to be computed to the nearest month or to the nearest day.
The computations of average capital account balances to the nearest month and the division of net
income for Alb & Bay LLP for 2005 are as follows:
ALB & BAY LLP
Computation of Average Capital Account Balances
For Year Ended December 31, 2005
Average
Increase Capital X Fraction = Capital
(Decrease) Account of Year Account
Partner Date in Capital Balance Unchanged Balances
Alb Jan.1 400,000 400,000 1⁄4 OR 3/12 100,000
Apr.1 100,000 500,000 3⁄4 OR 9/12 375,000
475,000
Bay Jan. 1 800,000 800,000 1⁄2 OR 6/12 400,000
July 1 (50,000) 750,000 1⁄2 375,000
775,000
Total average capital account balances for Alb and Bay 1,250,000
Division of net income:
To Alb: $300,000 * $475,000/$1,250,000 = $ 114,000
To Bay: $300,000 *$775,000/$1,250,000 = $ 186,000
Total net income $ 300,000
journal entry is:
Income Summary 300,000
Alb, Capital 114,000
Bay, Capital 186,000
Interest on Partners’ Capital Account Balances with Remaining
Net Income or Loss Divided in Specified Ratio
Again refer to Alb & Bay LLP with a net income of $300,000 for 2005 and capital account balances as
shown on page 30. Assume that the partnership contract allows interest on partners’ average capital
account balances at 15%, with any remaining net income or loss to be divided equally. The net income
of $300,000 for 2005 is divided as follows:

Alb Bay Combined

Interest on average capital account balances:
Alb: $475,000 * 0.15 $ 71,250 $ 71,250
Bay: $775,000 * 0.15 $116,250 116,250
Subtotal $187,500
Remainder :($300,000 - $187,500)
divided equally 56,250 56,250 112,500
Totals $127,500 $172,500 $300,000

journal entry is:

Income Summary 300,000
Alb, Capital 127,500
Bay, Capital 172,500
************************************************************************************

As a separate case, assume that Alb & Bay LLP had a net loss of $10,000 for the year ended December
31, 2005. If the partnership contract provides for allowing interest on capital accounts, this provision
must be enforced regardless of whether operations are profitable or unprofitable. The only justification for
omitting the allowance of interest on partners’ capital accounts during a loss year would be in the case
of a partnership contract containing a specific provision requiring such omission. Note in the
following analysis that the $10,000 debit balance of the Income Summary ledger account resulting
from the net loss is increased by the allowance of interest to $197,500, which is divided equally:

Alb Bay Combined

Interest on average capital account balances:
Alb: $475,000 * 0.15 $ 71,250 $ 71,250
Bay: $775,000 * 0.15 $116,250 116,250
Subtotal $ 187,500
Resulting deficiency ($10,000 - $187,500)
divided equally (98,750) (98,750) 197,500
Totals $ (27,500) $ 17,500 $ (10,000)
The journal entry to close the Income Summary ledger account on December 31, 2005,
is shown below:
Alb, Capital 27,500
Income Summary 10,000
Bay, Capital 17,500
To record division of net loss for 2005.
Interest on partners’ capital accounts is not an expense of the partnership, but interest on loans from
partners is recognized as expense and a factor in the measurement of net income or loss of the
partnership. Similarly, interest earned on loans to partners is recognized as partnership revenue.

Salary Allowance with Resultant Net Income or Loss Divided in Specified Ratio
Salaries and drawings are not the same thing. Because the term salaries suggest weekly or monthly cash payments
for personal services that are recognized as operating expenses by the limited liability partnership, accountants
should be specific in defining the terminology used in accounting for a partnership. This text uses the term drawings
in only one sense: a withdrawal of cash or other assets that reduces the partner’s equity but has no part in the
division of net income. In the discussion of partnership accounting, the word salaries mean an operating expense
included in measuring net income or loss. When the term salaries is used with this meaning, the division of net
income is the same, regardless of whether the salaries have been paid.

assume that the partnership contract provides for an annual salary of $100,000 to Alb and $60,000 to Bay,
with resultant net income or loss to be divided equally. The salaries are paid monthly during the year. The
net income of $140,000 for 2005 is divided as follows:
Alb Bay Combined
Salaries $100,000 $ 60,000 $160,000
Net income ($300,000 - $160,000)
divided equally 70,000 70,000 140,000
Totals $170,000 $130,000 $300,000

The following journal entries are required for the foregoing:

1. Monthly journal entries debiting Partners’ Salaries Expense, $13,333 ($160,000 / 12 = $13,333) and
crediting Alb, Capital, $8,333 ($100,000 /12 = $8,333) and Bay, Capital, $5,000 ($60,000 / 12 = $5,000).
The journal entry is:
Salaries expense 13,333
Alb capital 8,333
Bay capital 5,000
2. Monthly journal entries debiting Alb, Drawing, $8,333 and Bay, Drawing, $5,000 and
crediting Cash, $13,333.
The journal entry is:
Alb capital 8,333
Bay capital 5,000
Cash 13,333

3. End-of-year journal entry debiting Income Summary, $140,000, and crediting Alb,
Capital, $70,000 and Bay, Capital, $70,000.
The journal entry is:
Income summary 140,000
Alb capital 70,000
Bay capital 70,000

Salaries to Partners with Interest on Capital Accounts

Many limited liability partnerships divide income or loss by allowing salaries to partners and also interest on their
capital account balances. Any resultant net income or loss is divided equally or in some other ratio. Such plans have
the merit of recognizing that the value of personal services rendered by different partners may vary, and that
differences in amounts invested also warrant recognition in an equitable plan for sharing net income or loss.
To illustrate, assume that the partnership contract for Alb & Bay LLP provides for the following:
1. Annual salaries of $100,000 to Alb and $60,000 to Bay, recognized as operating expense of the partnership, with
salaries to be paid monthly.
2. Interest on average capital account balances.
3. Remaining net income or loss divided equally.
Assuming income of $300,000 for 2005 before annual salaries expense, the $140,000
net income [$300,000- ($100,000+ $60,000) = $140,000] is divided as follows:

Alb Bay Combined

Interest on average capital account balances:
Alb: $475,000 * 0.15 $71,250 $ 71,250
Bay: $775,000* 0.15 $116,250 116,250
Subtotal $187,500
Resulting deficiency ($187,500- $140,000)
divided equally (23,750) (23,750) (47,500)
Totals $47,500 $ 92,500 $140,000
The journal entries to recognize partners’ salaries expense, partners’ withdrawals of the
salaries, and closing of the Income Summary ledger account are similar to those described
on page 35

The journal entry to recognize partners’ salaries expense is:

Salaries expense 160,000
 Alb capital 100,000
Bay capital 60,000

The journal entry for withdrawals of the salaries is:

Alb capital 100,000
Bay capital 60,000
Cash 160,000

The journal entry entry is:

Income summary 140,000
Alb capital 47,500
Bay capital 92,500

Bonus to Managing Partner Based on Income

A partnership contract may provide for a bonus to the managing partner equal to a specified percentage of income.
The contract should state whether the basis of the bonus is net income without deduction of the bonus (before
deduction of bonus) as an operating expense or income after the bonus.

For example, assume that the Alb & Bay LLP partnership contract provides for a bonus to Partner Alb of 25% of net
income (without deduction of the bonus) and that the remaining income is divided equally. The net income is
$300,000. After the bonus of $75,000 ($300,000* 0.25)= $75,000) to Alb, the remaining $225,000 of income is
divided $112,500 to Alb and $112,500 to Bay. Thus, Alb’s share of income is $187,500 ($75,000 + $112,500 =
$187,500), and Bay’s share is $112,500; the bonus is not recognized as an operating expense of the limited liability
partnership.

If the partnership contract provided for a bonus of 25% of income after the bonus to Partner Alb, the bonus is
computed as follows:

Income before bonus = income after bonus + bonus

300,000 = Bonus + income after bonus
Let X income after bonus
300,000 = 0.25X + X
$300,000 income before bonus = 1.25 X
$300,000 income before bonus/1.25 = 1.25 X/1.25
X = $240,000

bonus to Partner Alb = 0.25*240,000

= $60,000
An alternative computation consists of converting the bonus percentage to a fraction., 25% is converted to 1⁄4; and
adding the numerator to the denominator, the 1⁄4 becomes 1⁄5(4 + 1= 5). One-fifth of $300,000 equals $60,000, the
bonus to Partner Alb.Thus, the income of $300,000 in this case is divided $180,000 ($60,000 +$120,000) to Alb and
$120,000 to Bay, and the $60,000 bonus is recognized as an operating expense of the partnership.

Financial Statements for an LLP

Income Statement
Explanations of the division of net income among partners may be included in the partnership’s income statement or
in a note to the financial statements. This information is referred to as the division of net income section of the
income statement. The following illustration for Alb & Bay LLP shows, in a condensed income statement for the
year ended December 31, 2005, the division of net income as shown above and the disclosure of
partners’ salaries expense, a related party item.
ALB & BAY LLP
Income Statement
For Year Ended December 31, 2005
Net sales $3,000,000
Cost of goods sold 1,800,000
Gross margin on sales $1,200,000
Partners’ salaries expense $ 160,000
Other operating expenses 900,000 1,060,000
Net income $ 140,000
Division of net income:
Partner Alb $ 47,500
Partner Bay 92,500

Total $140,00

Note that because a partnership is not subject to income taxes, there is no income taxes expense in the
foregoing income statement. A note to the partnership’s financial statements may disclose this fact and
explain that the partners are taxed for their shares of partnership income, including their salaries.
Statement of Partners’ Capital
Partners and other users of limited liability partnership financial statements generally want a complete explanation
of the changes in the partners’ capital accounts each year. To meet this need, a statement of partners’ capital is
prepared. The following illustrative statement of partners’ capital for Alb & Bay LLP is based on the capital
accounts includes the division of net income illustrated in the foregoing income statement.
ALB & BAY LLP
Statement of Partners’ Capital
For Year Ended December 31, 2005
Alb Partner Bay Partner Combined
Partners’ original investments,
beginning of year $400,000 $800,000 $1,200,000
Additional investment(withdrawal) of capital 100,000 (50,000) 50,000
Balances before salaries, net income, and drawings $500,000 $750,000 $1,250,000
Add: Salaries 100,000 60,000 160,000
Net income 47,500 92,500 140,000
Subtotals $647,500 $902,500 $1,550,000
Less: Drawings 100,000 60,000 160,000
Partners’ capital, end of year $547,500 $842,500
Partners’ capital at end of year is reported as owners’ equity in the December 31, 2005,
balance sheet of the partnership that follows.

Balance Sheet
A condensed balance sheet for Alb & Bay LLP on December 31, 2005, is presented below.
ALB & BAY LLP
Balance Sheet
December 31, 2005
Assets Liabilities and Partners’ Capital
Cash $50,000 Trade accounts payable $ 240,000
Trade accounts receivable 40,000 Long-term debt 370,000

Total liabilities $ 610,000

Inventories 360,000 Partners’ capital:
Plant assets (net) 1,550,000 Partner Alb $547,500
Total assets $2,000,000 Partner Bay 842,500 1,390,000
Total liabilities and partners’

Capital $2,000,000
Statement of Cash Flows:
A statement of cash flows is prepared for a partnership as it is for a corporation. This financial statement,
the preparation of which is explained and illustrated in intermediate accounting textbooks, displays the
net cash provided by operating activities, net cash used in investing activities, and net cash provided or
used in financing activities of the partnership.
A statement of cash flows for Alb & Bay LLP under the indirect method, which includes the
net income from the income statement on page 37 and the investments and combined drawings from the
statement of partners’ capital on page 37, is as follows:

CHANGES IN OWNERSHIP OF LIMITED LIABILITY PARTNERSHIPS

Admission of a New Partner (by purchasing from partner(s).
Acquisition of an Interest by Payment to One or More Partners
If a new partner acquires an interest from one or more of the existing partners, the event is
recorded by establishing a capital account for the new partner and decreasing the capital account balances
of the selling partner(s) by the same amount. No assets are received by the partnership; the transfer of
ownership is a private transaction between two or more partners.
As an illustration of this situation, assume that Lane and Mull, partners of Lane & Mull LLP, share net
income or losses equally and that each has a capital account balance of $60,000. Nash (with the consent
of Mull) acquires one-half of Lane’s interest in the partnership by a cash payment of $37,000 to Lane.
The journal entry to record this change in ownership follows:
Lane, Capital ($60,000* 50%) 30,000
Nash, Capital 30,000
To record transfer of one-half of Lane’s capital to Nash.
Investment in Partnership by New Partner
A new partner may gain admission by investing assets in the limited liability partnership, thus increasing its total
assets and partners’ capital. For example, assume that Wolk and Yary, partners of Wolk & Yary LLP, share net
income or loss equally and that each has a capital account balance of $60,000. Assume also that the carrying
amounts of the partnership assets are approximately equal to current fair values and that Zell owns land that might
be used for expansion of partnership operations. Wolk and Yary agree to admit Zell to the partnership by investment
of the land; net income and losses of the new firm are to be shared equally. The land had cost Zell $50,000, but has a
current fair value of $80,000. The admission of Zell is recorded by the partnership as follows:

Land 80,000
Zell, Capital 80,000
To record admission of Zell to partnership.
Zell has a capital account balance of $80,000 and thus owns a 40% [$80,000 ($60,000 +
$60,000+ $80,000) * 0.40] interest in the net assets of the firm. The fact that the three
partners share net income and losses equally does not require that their capital account balances be
equal.
Bonus or Goodwill Allowed to Existing Partners
In a profitable, well-established firm, the existing partners may insist that a portion of the investment by a new
partner be allocated to them as a bonus or that goodwill be recognized and credited to the existing partners. The new
partner may agree to such terms because of the benefits to be gained by becoming a member of a firm with high
earning power.

Bonus to Existing Partners

Assume that in Cain & Duke LLP, the two partners share net income and losses equally and have capital account
balances of $45,000 each. The carrying amounts of the partnership net assets approximate current fair values. The
partners agree to admit Eck to a one-third interest in capital and a one-third share in net income or losses for a cash
investment of $60,000. The net assets of the new firm amount to $150,000 ($45,000 + $45,000 + $60,000=
$150,000). The following journal entry gives Eck a one-third interest in capital and credits the $10,000 bonus
($60,000 - $50,000 = $10,000) equally to Cain and Duke in accordance with their prior contract to share net income
and losses equally:

The journal entry is:

Cash 60,000
Cain, Capital ($10,000 1⁄2) 5,000
Duke, Capital ($10,000 1⁄2) 5,000
Eck, Capital ($150,000 1⁄3) 50,000
To record investment by Eck for a one-third interest in capital, with bonus of $10,000 divided equally between Cain
and Duke.

Goodwill to Existing Partners

In the foregoing illustration, Eck invested $60,000 but received a capital account balance of only $50,000,
representing a one-third interest in the net assets of the firm. Eck might prefer that the full amount invested, $60,000,
be credited to Eck’s capital account. This might be done while still allotting Eck a one-third interest if goodwill is
recognized by the partnership, with the offsetting credit divided equally between the two existing partners. If
Eck is to be given a one-third interest represented by a capital account balance of $60,000, the indicated total capital
of the partnership is $180,000 ($60,000 * 3 = $180,000), and the total capital of Cain and Duke must equal $120,000
($180,000 * 2⁄3 = $120,000). Because their present combined capital account balances amount to $90,000, a write-up
of $30,000 in the net assets of the partnership is recorded as follows:

Cash 60,000
Goodwill ($120,000 - $90,000) 30,000
Cain, Capital ($30,000*1⁄2) 15,000
Duke, Capital ($30,000 * 1⁄2) 15,000
Eck, Capital 60,000
To record investment by Eck for a one-third interest in capital, with credit offsetting goodwill of $30,000
divided equally between Cain and Duke.
Evaluation of Bonus and Goodwill Methods
When a new partner invests an amount larger than the carrying amount of the interest acquired, the transaction
should be recorded by allowing a bonus to the existing partners. The bonus method adheres to the valuation
principle and treats the partnership as a going concern.

The alternative method of recording the goodwill implied by the amount invested by the new partner is not
considered acceptable by the author. Use of the goodwill method signifies the substitution of estimated current fair
value of an asset rather than valuation on a cost basis. The goodwill of $30,000 recognized in the foregoing example
was not paid for by the partnership. Its existence is implied by the amount invested by the new partner for a one-
third interest in the firm. The amount invested by the new partner may have been influenced by many factors, some
of which may be personal rather than economic in nature. Apart from the questionable theoretical basis for such
recognition of goodwill, there are other practical difficulties. The presence of goodwill created in this manner is
likely to evoke criticism of the partnership’s financial statements, and such criticism may cause the partnership to
write off the goodwill. Also, if the partnership were liquidated, the goodwill would have to be written off as a loss

Fairness of Asset Valuation

In the foregoing examples of bonus or goodwill allowed to the existing partners, it was assumed that the carrying
amounts of assets of the partnership approximated current fair values. However, if land and buildings, for example,
have been owned by the partnership for many years, their carrying amounts and current fair values may be
significantly different.
To illustrate this problem, assume that the net assets of Cain & Duke LLP, carried at $90,000, were estimated to
have a current fair value of $120,000 at the time of admission of Eck as a partner. The previous example required
Eck to receive a one-third interest in partnership net assets for an investment of $60,000. Why not write up the
partnership’s identifiable assets from $90,000 to $120,000, with a corresponding increase in the capital account
balances of the existing partners? Neither a bonus nor the recognition of goodwill then would be necessary to record
the admission of Eck with a one-third interest in net assets for an investment of $60,000 because this investment is
equal to one-third of the total partnership capital of $180,000 ($120,000 + $60,000 = $180,000). Such restatement of
asset values would not be acceptable practice in a corporation when the market price of its capital stock had risen. If
one assumes the existence of certain conditions in a partnership, adherence to cost as the basis for asset valuation is
as appropriate a policy as for a corporation. These specific conditions are that the income-sharing ratio should be the
same as the share of equity of each partner and that the income-sharing ratio should continue unchanged. When
these conditions do not exist, a restatement of net assets from carrying amount to current fair value may be the best
way of achieving equity among the partners.

Bonus or Goodwill Allowed to New Partner

A new partner may be admitted to a limited liability partnership because it needs cash or because the new partner
has valuable skills and business contacts. To ensure the admission of the new partner, the present firm may offer the
new partner a larger equity in net assets than the amount invested by the new partner.
Bonus to New Partner
Assume that the two partners of Farr & Gold LLP, who share net income and losses equally and have capital
account balances of $35,000 each, offer Hart a one-third interest in net assets and a one-third share of net income or
losses for an investment of $20,000 cash. Their offer is based on a need for more cash and on the conviction that
Hart’s personal skills and business contacts will be valuable to the partnership. The investment of $20,000 by Hart,
when added to the existing capital of $70,000, gives total capital of $90,000 ($20,000 + $70,000 = $90,000), of
which Hart is entitled to one-third, or $30,000 ($90,000 *1⁄3 = $30,000). The excess of Hart’s capital account
balance over the amount invested represents a $10,000 bonus ($30,000 - $20,000 = $10,000) allowed to Hart by
Farr and Gold. Because those partners share net income or losses equally, the $10,000 bonus is debited to
their capital accounts in equal amounts, as shown by the following journal entry to record the admission of Hart to
the partnership:

Cash 20,000
Farr, Capital ($10,000 * 1⁄2) 5,000
Gold, Capital ($10,000 * 1⁄2) 5,000
Hart, Capital 30,000
To record admission of Hart, with bonus of $10,000 from Farr and Gold

In outlining this method of accounting for the admission of Hart, it is assumed that the net assets of the partnership
were valued properly. If the admission of the new partner to a one-third interest for an investment of $20,000 was
based on recognition that the net assets of the existing partnership were worth only $40,000, consideration should be
given to writing down net assets by $30,000 ($70,000 - $40,000 = $30,000). Such write-downs would be appropriate
if, for example, trade accounts receivable included doubtful accounts or if inventories were obsolete.

Goodwill to New Partner

Assume that the new partner Hart is the owner of a successful single proprietorship that Hart invests in the
partnership rather than making an investment in cash. Using the same data as in the preceding example, assume that
Farr and Gold, with capital account balances of $35,000 each, give Hart a one-third interest in net assets and net
income or losses. The identifiable tangible and intangible net assets of the proprietorship owned by Hart are worth
$20,000, but, because of its superior earnings record, a current fair value for the total net assets is agreed to be
$35,000. The admission of Hart to the partnership is recorded as shown below:

Identifiable Tangible and Intangible Net Assets 20,000

Goodwill ($35,000 - $20,000) 15,000
Hart, Capital 35,000
To record admission of Hart; goodwill is attributable to superior earnings of single proprietorship invested by Hart.

The point to be stressed is that generally goodwill is recognized as part of the investment of a new partner only when
the new partner invests in the partnership a business enterprise of superior earning power. If Hart is admitted for a
cash investment and is credited with a capital account balance larger than the cash invested, the difference should be
recorded as a bonus to Hart from the existing partners, or undervalued tangible or identifiable intangible assets
should be written up to current fair value. Goodwill should be recognized only when substantiated by objective
evidence, such as the acquisition of a profitable business enterprise.

Retirement of a Partner

A partner retiring from a limited liability partnership usually receives cash or other assets from the
partnership. It is also possible that a retiring partner might arrange for the sale of his or her partnership
interest to one or more of the continuing partners or to an outsider. Because the accounting principles
applicable to the latter situation already have been considered, the discussion of the retirement of a
partner is limited to the situation in which the retiring partner receives assets of the partnership.
An assumption underlying this discussion is that the retiring partner has a right to withdraw under the
terms of the partnership contract. A partner always has the power to withdraw, as distinguished from the
right to withdraw. A partner who withdraws in violation of the terms of the partnership contract, and
without the consent of the other partners, may be liable for damages to the other partners.
Computation of the Settlement Price
What is a fair measurement of the equity of a retiring partner? A first indication is the retiring partner’s capital
account balance, but this amount may need to be adjusted before it represents an equitable settlement price.
Adjustments may include the correction of errors in accounting data or the recognition of differences between
carrying amounts of partnership net assets and their current fair values. Before making any adjustments, the
accountant should refer to the partnership contract, which may contain provisions for computing the amount to be
paid to a retiring partner. For example, these provisions might require an appraisal of assets, an audit by independent
public accountants, or a valuation of the partnership as a going concern according to a prescribed formula. If the
partnership has not maintained accurate accounting records or has not been audited, it is possible that the partners’
capital account balances are misstated because of incorrect depreciation expense, failure to provide for doubtful
accounts expense, and other accounting deficiencies.

If the partnership contract does not contain provisions for the computation of the retiring partner’s equity,
the accountant may obtain written authorization from the partners to use a specific method to determine
an equitable settlement price.
In most cases, the equity of the retiring partner is computed on the basis of current fair values of
partnership net assets. The gain or loss indicated by the difference between the carrying amounts of assets
and their current fair values is divided in the income-sharing ratio. After the equity of the retiring partner
has been computed in terms of current fair values for assets, the partners may agree to settle by payment
of this amount, or they may agree on a different amount. The computation of an estimated current fair
value for the retiring partner’s equity is a necessary step in reaching a settlement. An independent
decision is made whether to recognize the current fair values and the related changes in partners’
capital in the partnership’s accounting records.
Bonus to Retiring Partner
The partnership contract may provide for the computation of internally generated goodwill at the time of a partner’s
retirement and may specify the methods for computing the goodwill. Generally, the amount of the computed
goodwill is allocated to the partners in the income-sharing ratio. For example, assume that partner Lund is to retire
from Jorb, Kent & Lund LLP. Each partner has a capital account balance of $60,000, and net income and
losses are shared equally. The partnership contract provides that a retiring partner is to receive the balance of the
retiring partner’s capital account plus a share of any internally generated goodwill. At the time of Lund’s retirement,
goodwill in the amount of $30,000 is computed to the mutual satisfaction of the partners. In the opinion of the
author, this goodwill should not be recognized in the accounting records of the partnership by a $30,000 debit to
Goodwill and a $10,000 credit to each partner’s capital account.
Serious objections exist to recording goodwill as determined in this fashion. Because only $10,000 of the goodwill is
included in the payment for Lund’s equity, the remaining $20,000 of goodwill has not been paid for by the
partnership. Its display in the balance sheet of the partnership is not supported by either the valuation principle or
reliable evidence. The fact that the partners “voted” for $30,000 of goodwill does not meet the need for reliable
evidence of asset values. As an alternative, it would be possible to recognize only $10,000 of goodwill and credit
Lund’s capital account for the same amount, because this amount was paid for by the partnership as a condition of
Lund’s retirement. This method is perhaps more justifiable, but reliable evidence that goodwill exists still is lacking.
(As indicted on page 41, FASB Statement No. 142, “Accounting for Goodwill . . . ,” provides that goodwill attaches
only to a business as a whole and is recognized only when a business is acquired.) The most satisfactory method of
accounting for the retirement of partner Lund is to record the amount paid to Lund for goodwill as a $10,000 bonus.
Because the settlement with Lund is for the balance of Lund’s capital account of $60,000, plus estimated goodwill
of $10,000, the following journal entry to record Lund’s retirement is recommended:

lund, Capital 60,000

Jorb, Capital ($10,000 1⁄2) 5,000
Kent, Capital ($10,000 1⁄2) 5,000
Cash 70,000
The bonus method illustrated here is appropriate whenever the settlement with the retiring partner exceeds
the carrying amount of that partner’s capital. The agreement for settlement may or may not use the term
goodwill; the essence of the matter is the determination of the amount to be paid to the retiring partner.

Bonus to Continuing Partners

A partner anxious to escape from an unsatisfactory business situation may accept less than his or her partnership
equity on retirement. In other cases, willingness by a retiring partner to accept a settlement below carrying amount
may reflect personal problems. Another possible explanation is that the retiring partner considers the net assets of
the partnership to be overvalued or anticipates less partnership net income in future years. In brief, there are many
factors that may induce a partner to accept less than the carrying amount of his or her capital account balance on
withdrawal from the partnership. Because a settlement below carrying amount seldom is supported by objective
evidence of overvaluation of assets, the preferred accounting treatment is to leave net asset valuations undisturbed
unless a large amount of impaired goodwill is carried in the accounting records as a result of the prior admission of
a partner as described on page 45. The difference between the retiring partner’s capital account balance and the
amount paid in settlement should be allocated as a bonus to the continuing partners.
For example, assume that the three partners of Merz, Noll & Park LLP share net income or losses equally, and that
each has a capital account balance of $60,000. Noll retires from the partnership and receives $50,000. The journal
entry to record Noll’s retirement
follows:

Noll, Capital 60,000

Cash 50,000
Merz, Capital ($10,000 1⁄2) 5,000
Park, Capital ($10,000 1⁄2) 5,000
To record retirement of Partner Noll for an amount less than carrying
amount of Noll’s equity, with a bonus to continuing partners.
The final settlement with a retiring partner often is deferred for some time after the partner’s withdrawal
to permit the accumulation of cash, the measurement of net income to date
of withdrawal, the obtaining of bank loans, or other acts needed to complete the transaction.
Death of a Partner
Limited liability partnership contracts often provide that partners shall acquire life insurance policies on each others’
lives so that cash will be available for settlement with the estate of a deceased partner. A buy-sell agreement may be
formed by the partners, whereby the partners commit their estates to sell their equities in the partnership and the
surviving partners to acquire such equities. Another form of such an agreement gives the surviving partners an
option to buy, or right of first refusal, rather than imposing on the partnership an obligation to acquire the deceased
partner’s equity.

Ex.2-2 On January 2, 2005, Carle and Dody established Carle & Dody LLP, with Carle investing
$80,000 and Dody investing $70,000 on that date. The income-sharing provisions of the
partnership contract were as follows:
1. Salaries of $30,000 per annum to each partner.
2. Interest at 6% per annum on beginning capital account balances of each partner.
3. Remaining income or loss divided equally.
Pre-salary income of Carle & Dody LLP for the month of January 2005 was $20,000. Neither partner had
a drawing for that month.
Prepare journal entries for Carle & Dody LLP on January 31, 2005, to provide for partners’ salaries and
close the Income Summary ledger account. Show supporting computations in the explanations for the
entries.
Solution:
31/5/2005 partners’ salaries expenses 5,000
Carle capital 2,500
Dody capital 2,500
31/5/2005 income summary 15,000
Carle capital 7,525
Dody capital 7,475

Carle Dody
Interest on capital beginning 80,000*6%/12 400
70,000*6%/12 350
Remainder equally 7,125 7,125
Total $ 7,125 $ 7,475
(Exercise 2.2 ---- On January 2, 2005, Carle and Dody established Carle & Dody LLP, with Carle investing
$80,000 and Dody investing $70,000 on that date. The income-sharing provisions of the partnership
contract were as follows:
1. Salaries of $30,000 per annum to each partner.
2. Interest at 6% per annum on beginning capital account balances of each partner.
3. Remaining income or loss divided equally.
Pre-salary income of Carle & Dody LLP for the month of January 2005 was $20,000. Neither partner had
a drawing for that month.
Prepare journal entries for Carle & Dody LLP on January 31, 2005, to provide for partners’ salaries and
close the Income Summary ledger account. Show supporting computations in the explanations for the
entries.
Solution:
Partner’s salaries 5,000
Carle capital 2,500 (30,000/12)
Dody capital 2,500 (30,000/12)

Income summery 15,000

Carle capital 7,525
Dody capital 7,475

Division of net income (20,000-5,000).

Carle dody
:Interest on beginning capital
Carle (80,000* 6%)/12 400
Dody (70,000*6%)/12 350
Remaining equally 7,125 7,125
Total $7,525 $7,475
Exercise 2.3---Activity in the capital accounts of the partners of Webb & Yu LLP for the fiscal year
:ended December 31, 2005, follows
Webb, Capital Yu, Capital
Balances, Jan. 1 $40,000 $80,000
Investment, July 1 20,000
Withdrawal, Oct. 1 40,000

.Net income of Webb & Yu LLP for the year ended December 31, 2005, amounted to $48,000
Prepare a working paper to compute the division of the $48,000 net income of Webb & Yu LLP under
:each of the following assumptions
.a. The partnership contract is silent as to sharing of net income and losses
:Solution
.a. Equally in the absence of agreement. $24,000 to Webb and $24,000 to Yu

b. Net income and losses are divided on the basis of average capital account balances (not
.)including the net income or loss for the current year
:Solution
Computation of Average Capital Account Balances
For Year Ended December 31, 2005
Average
Increase Capital X Fraction = Capital
(Decrease) Account of Year Account
Partner Date in Capital Balance Unchanged Balances
Webb beg. Capital 1/1/2005 40,000 40,000 6/12 20,000
Webb investment 1/7/2005 20,000 60,000 6/12 30,000
Total $ 50,000
Yu 1/1/2005 80,000 80,000 9/12 60,000
Yu 1/10/2005 (40,000) 40,000 3/12 10,000
Total $70,000
Subtotal $120,000
Division of net income Webb Yu combined
Webb 50,000/120,000*48,000 $20,000 $20,000
Yu 70,000/120,000*48,000 $28,000 $28,000
 Total $20,000 $28,000 $48,000

.c. Net income and losses are divided on the basis of beginning capital account balances
Division of net income Webb Yu combined
Webb 40,000/120,000*48,000 $16,000 $16,000
Yu 80,000/120,000*48,000 $32,000 $28,000
Total $16,000 $32,000 $48,000

d. Net income and losses are divided on the basis of ending capital account balances (not
.)including the net income or loss for the current year
Division of net income Webb Yu combined
Webb 60,000/100,000*48,000 $28,800 $28,800
Yu 40,000/100,000*48,000 $19,200 $19,200
Total $28,800 $19,200 $48,000
Exercise 2- 4
The partnership contract of Ray, Stan & Todd LLP provided that Ray was to receive a bonus
equal to 20% of income and that the remaining income or loss was to be divided 40% each
to Ray and Stan and 20% to Todd. Income of Ray, Stan & Todd LLP for 2005 (before the
.bonus) amounted to $127,200
Explain two alternative ways in which the bonus provision might be interpreted, and prepare a working
paper to compute the division of the $127,200 income of Ray, Stan & Todd LLP for 2005 under each
.interpretation

:Solution
.1st. Alternative Ray is entitled to receive 20% of net income without deduction of bonus
Division of net income Ray Stan Todd Combined
Ray 127,200*20% bonus 25,440 25,440
Ray 127,200*80%*40% 40,704 40,704
Stan 127,200*80%*40% 40,704 40,704
Todd 127,200*80%*20% 20,352 20,352
Total $66,144 $40,704 $20,352 $127,200
101,760 = 80%*127,200
2nd Alternative Ray is entitled to receive 20% of net income after deduction of bonus. The
later is logical, because net income is the total revenues less total expenses including bonus.
Although for a partnership a bonus based on a pre-bonus income is included in the division of
.net income
Division of net income Ray Stan Todd Combined
Ray 127,200*1/6 bonus 21,200 21,200
Ray 127,200*5/6%*40% 42,400 42,400
Stan 127,200*5/6*40% 42,400 42,400
Todd 127,200*5/6*20% 21,200 21,200
Total $63,600 $42,400 $21.200 $127,200

Exercise 2-5 -----The partnership contract of Jones, King & Lane LLP provided for the
division of net income or losses in the following manner:
1. Bonus of 20% of income before the bonus to Jones.
2. Interest at 15% on average capital account balances to each partner.
3. Residual income or loss equally to each partner.
Net income of Jones, King & Lane LLP for 2005 was $90,000, and the average capital
account balances for that year were Jones, $100,000; King, $200,000; and Lane,
$300,000.
Prepare a working paper to compute each partner’s share of the 2005 net income of
.Jones, King & Lane LLP
Division of net income $90,000,
Jones King Lane combined

Bonus to Jones 20%*90,000 18,000 18,000

Interest on average capital15% 15,000 30,000 45,000 90,000

TOTAL 33,000 30,000 45,000 108,000

Remaining equally (6,000) (6,000) (6,000) (18,000)

Total $ 27,000 $ 24,000 $ 39,000 $ 90,000

Exercise 2-6…..The partnership contract of Ann, Bud & Cal LLP provides for the remuneration

of partners as follows:

1. Salaries of $40,000 to Ann, $35,000 to Bud, and $30,000 to Cal, to be recognized annually
as operating expense of the partnership in the measurement of net income.

2. Bonus of 10% of income after salaries and the bonus to Ann.

3. Remaining net income or loss 30% to Ann, 20% to Bud, and 50% to Cal.

Income of Ann, Bud & Cal LLP before partners’ salaries and Ann’s bonus was $215,000 for

the fiscal year ended December 31, 2005.

Prepare journal entries for Ann, Bud & Cal LLP on December 31, 2005, to:

(1) accrue partners’ salaries and Ann’s bonus.

(2) close the Income Summary ledger account (credit balance of $100,000) and divide the

net income among the partners. Show supporting computations in the explanation for

the second journal entry.

Solution:

Journal entries for Ann, Bud & Cal LLP, Dec. 31, 2005:

1. Partners’ Salaries Expense ($40,000 + $35,000 + $30,000) 105,000

Bonus Expense ($110,000 x1/11 10,000

Ann, Capital ($40,000 + $10,000) 50,000

Bud, Capital 35,000

Cal, Capital 30,000

To accrue salaries to partners and bonus after salaries and bonus to Ann.

2. Income summary 215,000-(105,000+10,000) 100,000

Ann Capital 100,000*30% 30,000

Bud Capital 100,000*20% 20,000

Cal Capital 100,000*50% 50,000

To record division of net income.

Exercise 2-7……The partnership contract for Bates & Carter LLP provided for salaries to partners
and the division of net income or losses as follows:

1. Salaries of $40,000 a year to Bates and $60,000 a year to Carter.

2. Interest at 12% a year on beginning capital account balances.

3. Remaining net income or loss 70% to Bates and 30% to Carter.

For the fiscal year ended December 31, 2005, Bates & Carter LLP had pre-salaries income of
$200,000. Capital account balances on January 1, 2005, were $400,000 for Bates and $500,000
for Carter; Bates invested an additional $100,000 in the partnership on September 30, 2005. In
accordance with the partnership contract, both partners drew their salary allowances in cash
from the partnership during the year.

Prepare journal entries for Bates & Carter LLP on December 31, 2005, to:

(1) accrue partners’ salaries.

(2) close the Income Summary (credit balance of $100,000) and drawing accounts. Show
supporting computations in the journal entry closing the Income Summary account.

Solution:

journal entries for Bates & Carter LLP, Dec. 31, 2005:

Partners’ Salaries Expense ($40,000 + $60,000) 100,000

Bates, Capital 40,000

Carter, Capital 60,000

To accrue salaries to partners.

Income Summary ($200,000 – $100,000) 100,000

Bates, Capital 42,400

Carter, Capital 57,600

To record division of net income as follows:

Bates Carter Combined

Interest $48,000 $60,000 $108,000

Remainder (5,600 ) (2,400 ) (8,000 )

Totals $42,400 $57,600 $100,000

Bates, Capital 40,000

Carter Capital 60,000

Bates, Drawing 40,000

Cater, Drawing 60,000

Exercise 2-8… Emma Neal and Sally Drew are partners of Neal & Drew LLP sharing net income

or losses equally; each has a capital account balance of $200,000. Sally Drew (with the

consent of Neal) sold one-fifth of her interest to her daughter Paula for $50,000, with

payment to be made to Sally Drew in five annual installments of $10,000, plus interest at

15% on the unpaid balance.

Prepare a journal entry for Neal, Drew & Drew LLP to record the change in ownership,

and explain why you would or would not recommend a change in the valuation of net assets

in the accounting records of Neal, Drew & Drew LLP.

Solution:

Journal entry for Neal, Drew & Drew LLP:

Sally Drew, Capital ($200,000 x1/5 40,000

Paula Drew, Capital 40,000

Exercise 2-9…..On January 31, 2005, Nancy Ross and John Clemon were admitted to Logan, Marsh &
Noble LLP (CPA firm), which had net assets of $120,000 prior to the admission and an income-sharing
ratio of Logan, 25%; Marsh, 35%; and Noble, 40%. Ross paid $20,000 to Carl Logan for one-half of his
20% share of partnership net assets on January 31, 2005, and Clemon invested $20,000 in the
partnership for a 10% interest in the net assets of Logan, Marsh, Noble, Ross & Clemon LLP. No goodwill
was to be recognized as a result of the admission of Ross and Clemon to the partnership.
Prepare separate journal entries on January 31, 2005, to record the admission of Ross and Clemon to
Logan, Marsh, Noble, Ross & Clemon LLP.

Solution:

Journal entries for Logan, Marsh, Noble, Ross & Clemon LLP, Jan. 31, 2005:

Logan, Capital ($120,000 x 0.20 x1/2 12,000

Ross, Capital 12,000

To record transfer of one-half of Logan’s capital to Ross.

Total capital before admission of Clemon 120,000

+ Investment made by clemon 20,000

Total capital after admission of clemon 140,000

X Clemon capital interest 10%

Clemon capital 14,000

Bonus to old partners 6,000

Shared among old partners based on income ratio

Logan 25%*6,000= 1,500

Marsh 35% *6,000= 2,100

Noble 40% *6,000= 2,400

Cash 20,000

Logan, Capital ($6,000 x 0.25) 1,500

Marsh, Capital ($6,000 x 0.35) 2,100

Noble, Capital ($6,000 x 0.40) 2,400

Clemon, Capital [($120,000 + $20,000) x 0.10] 14,000

To record investment by Clemon for a 10% interest in capital, with bonus to continuing partners divided
in their prior income-sharing ratio.
Exercise 2-10….Partners Arne and Bolt of Arne & Bolt LLP have capital account balances of $30,000 and
$20,000, respectively, and they share net income and losses in a 3 : 1 ratio.
Prepare journal entries to record the admission of Cope to Arne, Bolt & Cope LLP under each of the
following conditions:
a. Cope invests $30,000 for a one-fourth interest in net assets; the total partnership capital after Cope’s
admission is to be $80,000.
b. Cope invests $30,000, of which $10,000 is a bonus to Arne and Bolt. In conjunction with the admission
of Cope, the carrying amount of the inventories is increased by $16,000. Cope’s capital account is
credited for $20,000.

Solution:

Journal entries for admission of Cope to Arne, Bolt & Cope LLP:

a.

Cash 30,000

Arne, Capital ($10,000 x 0.75) 7,500

Bolt, Capital ($10,000 x 0.25) 2,500

Cope, Capital [($30,000 + $20,000 + $30,000) x 0.25] 20,000

To record admission of Cope; bonus of $10,000 ( $30,000 – $20,000 = $10,000) from Cope to Arne and
Bolt is divided in 3:1ratio

b.

Cash 30,000

Inventories 16,000

Arne, Capital [($10,000 + $16,000) x 0.75] 19,500

Bolt, Capital [($10,000 + $16,000) x 0.25] 6,500

Cope, Capital 20,000

To record admission of Cope; increase of $16,000 in the carrying amount of the

inventories, and bonus of $10,000 from Cope to Arne and Bolt divided in 3:1 ratio.
Exercise 2-11…Lamb and Meek, partners of Lamb & Meek LLP who share net income and losses 60% and
40%, respectively, had capital account balances of $70,000 and $60,000, respectively, on June 30, 2005.
On that date Lamb and Meek agreed to admit Niles to Lamb, Meek & Niles LLP with a one-third interest
in total partnership capital of $180,000 and a one-third share of net income or losses, for a cash
investment of $50,000.
Prepare a working paper to compute the balances of the Lamb, Capital, Meek, Capital
and Niles, Capital ledger accounts on June 30, 2005, following the admission of Niles to
Lamb, Meek & Niles LLP.

SOLUTION:

Total capital before admission 70,000+60,000 130,000

+ investment made by Niles 50,000

Total capital after admission 180,000

X Niles capital interest 1/3

Niles capital 60,000

Bonus to Niles 10,000

Shares between old partners

Lamb 60%*10,000 6,000

Meek 40%*10,000 4,000

The journal entry is:

Cash 50,000

Lamb 6,000

Meek 4,000

Niles capital 60,000

Q: Lamb and Meek, partners of Lamb & Meek LLP who share net income and losses 60% and 40%,
respectively, had capital account balances of $60,000 each, on June 30, 2005. On that date Lamb and
Meek agreed to admit Niles to Lamb, Meek & Niles LLP with a one-third interest in total partnership
capital of $180,000 and a one-third share of net income or losses, for a cash investment of $60,000.
Prepare a working paper to compute the balances of the Lamb, Capital, Meek, Capital
and Niles, Capital ledger accounts on June 30, 2005, following the admission of Niles to
Lamb, Meek & Niles LLP.

SOLUTION:

Total capital before admission 60,000+60,000 120,000

+ investment made by Niles 60,000

Total capital after admission 180,000

X Niles capital interest 1/3

Niles capital 60,000

The journal entry is:

Cash 60,000

Niles capital 60,000