Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
13–1
CHAPTER 13
UNDERSTANDING THE ISSUES
1. Partnerships are generally less formal than
other types of organizations and yet it is
important to consider a number of factors in
a partnership agreement. Individual part-
double taxation.
2. The use of a salary or bonus as a means of
allocating profits would be appropriate
when there is a desire to reward partners
3. Unless the profit-sharing agreement states
otherwise, all provisions of the agreement
should be satisfied except the final alloca-
tion of any remaining profits. Rather than
4. Generally speaking, a partner’s capital ac-
count would be debited for the following:
their share of any partnership losses, the
closing of the drawing account to capital,
and any withdrawals whose amount is
Ch. 13—Exercises 13–2
EXERCISES
EXERCISE 13-1
1. Investors in a partnership are not issued stock and have a capital balance rather than a
capital stock at par value account. Regarding the question of legal liability, a partnership is
2. A partnership is not a separate distinct taxable entity for income tax purposes; therefore,
the balance sheet would have no income tax accruals and the income statement would not
3. Salaries in a partnership are considered to be an allocation component for the purpose of
allocating profits rather than an expense of the partnership. The absence of a salary ex-
4. As is the case with salaries, interest on capital balances is a component for the purpose of
allocating profits rather than an actual expense of the partnership. If consideration is con-
veyed to a partner in an amount equal to their interest on invested capital, the consideration
EXERCISE 13-2
The students should employ the typical elements of a memo and be in good form. The content
should reflect a number of concerns. The agreement appears to be reasonably clear in
language and content. However, certain aspects do not seem to be equitable, including the
following:
EXERCISE 13-3
(1) Allocation of $220,000 of Partnership Income
Cumulative
Johnson Larson Kragen Total
Profit and loss percentage ................ 1/3 1/3 1/3
Salary ................................................ $50,000 $60,000 $ — $110,000
Exercise 13-3, Concluded
(2) Allocation of $34,000 of Partnership Loss
Cumulative
Johnson Larson Kragen Total
Profit and loss percentage ................ 1/3 1/3 1/3
Salary ................................................ $ 50,000 $ 60,000 $ — $110,000
(3) Allocation of $132,000 of Partnership Income
Cumulative
Johnson Larson Kragen Total
Profit and loss percentage ................ 1/3 1/3 1/3
Salary ................................................ $50,000 $60,000 $ — $110,000
Note A: Calculation of Annual Bonus
Bonus when Income Is $220,000
Bonus = 10% (Net Income – Bonus)
Bonus when Loss Is $34,000
No bonus is due since there is a loss versus income.
Bonus when Income Is $132,000
Bonus = 10% (Net Income – Bonus)
Note B: Stated Interest on Capital
Cumulative
Johnson Larson Kragen Total
Dollar ................................................. $4,000 $2,500 $14,500 $21,000
Percent of total .................................. 19.05% 11.90% 69.05% 100.00%
13–5 Ch. 13—Exercises
EXERCISE 13-4
1. The best way to measure invested capital is to use a weighted average. This will result in
proper consideration of varying levels of capital over time. In this particular case, it is antic-
ipated that significant capital contributions will be made over the first 18 months of opera-
2. The interest rate on invested capital should reflect the risk associated with the investment
in the partnership. Obviously, the higher the risk the higher the interest rate. However, a
proper assessment of the risk/return relationship may not be easy, and other alternative re-
turns on investment may be a good proxy for the interest rate. For example, the rate a bank
3. Capital balances reflect book values, not fair market values; therefore, the proposed buyout
provision seems inadequate. Given the nature of the proposed partnership business, metal
fabricating, there will be many assets whose book value does not equate to their fair market
4. Salaries are a component of a profit- or loss-sharing agreement and are not the same as
drawings. It is the drawings that are paid out over some period of time. Therefore, it is
5. Clearly, calculating a bonus as a percentage of income is the easiest method. However, it
Exercise 13-4, Concluded
6. Individual partners contribute to a partnership in a variety of ways, and a profit- or loss-
sharing agreement hopefully recognizes this by virtue of using a variety of provisions such
as interest on invested capital, salaries, bonuses, etc. Satisfying each provision to the
EXERCISE 13-5
Allocation of third year income based on original profit allocation:
Cumulative
Walker
Hayes Leaky Total
Salaries ................................................... $ 90,000 $ 90,000 $ 70,000 $250,000
Bonuses .................................................. 11,000 11,000 11,000 283,000
Allocation of third year income based on revised profit allocation and combined income of
$353,000:
Cumulative
Walker
Hayes Leaky Total
Salaries ................................................... $ 90,000 $ 90,000 $ 90,000 $270,000
Exercise 13-5, Continued
Allocation of third year income based on revised profit allocation and combined income of
$403,000:
Cumulative
Walker
Hayes Leaky Total
Salaries ................................................... $ 90,000 $ 90,000 $ 90,000 $270,000
Note A: Interest on Weighted-Average Capital, Walker
Number
Amount of Months Weighted
Invested Invested Dollars
$40,000 6 $240,000
55,000 6
330,000
Interest on Weighted-Average Capital, Hayes
Number
Amount of Months Weighted
Invested Invested Dollars
$30,000 6 $180,000
Interest on Weighted-Average Capital, Leaky
Number
Amount of Months Weighted
Invested Invested Dollars
$ 60,000 3 $ 180,000
185,000 3 555,000
Exercise 13-5, Concluded
Note B: Special Allocation to Leaky
If Leaky had joined with the outside investor and the net income was a minimum of $100,000,
the allocation of profits would have been as follows:
Outside Cumulative
Leaky
Investor Total
Salaries ................................................... $ 60,000 $ — $ 60,000
If Leaky had joined with the outside investor and the net income was a minimum of $150,000,
the allocation of profits would have been as follows:
Outside Cumulative
Leaky
Investor Total
Salaries ................................................... $ 60,000 $ — $ 60,000
Interest on capital .................................... — 6,250 66,250
Author's Note:
In addition to the above quantitative analysis there are other factors to consider such as the
following:
• Relative to the original partnership agreement, Hayes is not gaining significantly from the
proposed new arrangement.
• Hayes is being allocated interest on their capital including the required investment of
$15,000. What other alternatives might Hayes have for this capital? Could they earn more
than what is being offered in the revised agreement?
13–9 Ch. 13—Exercises
EXERCISE 13-6
Year 1—Allocation of $250,000 of Partnership Income
Cumulative
Banyan Schultz Witkowski Total
Witkowski Proposal
Profit and loss percentage ................ 1/3 1/3 1/3
Salary ................................................ $120,000 $80,000 $40,000 $240,000
Bonus (see Note A) ........................... — — 2,500 242,500
Year 2—Allocation of $300,000 of Partnership Income
Cumulative
Banyan Schultz Witkowski Total
Witkowski Proposal
Profit and loss percentage ................ 1/3 1/3 1/3
Salary ................................................ $120,000 $80,000 $40,000 $240,000
Bonus (see Note A) ........................... — — 7,000 247,000
Interest on capital .............................. 5,000 5,000 5,000 262,000
Exercise 13-6, Concluded
Year 3—Allocation of $360,000 of Partnership Income
Cumulative
Banyan Schultz Witkowski Total
Witkowski Proposal
Profit and loss percentage ................ 1/3 1/3 1/3
Salary ................................................ $120,000 $ 80,000 $40,000 $240,000
Note A: Calculation of Annual Bonus
Bonus when Income Is $250,000
Bonus percent ................................... 5% 10%
Based on income of .......................... $ 50,000 $ —
Amount of bonus ............................... $ 2,500 $ —
Bonus when Income Is $300,000
It appears that Witkowski would be well advised to accept the original partners’ proposal during
the initial 3-year term. If income can continue to grow at a 20% rate, only then may Witkowski’s
proposal prove to be the most advantageous. Certainly, the assumption of an annual growth
rate of 20% should be viewed with skepticism.
EXERCISE 13-7
Allocation of $168,000 of Partnership Income
Cumulative
Moore Probst Tanski Total
Profit and loss percentage ................ 20% 40% 40%
Interest on capital (see Note A) ........ $23,125 $ 1,500 $ 1,500 $ 26,125
Note A: Interest on Weighted-Average Capital, Moore
Number
Amount of Months Weighted
Invested Invested Dollars
$250,000 3 $ 750,000
225,000 9
2,025,000
Interest on Weighted-Average Capital, Probst
Interest on Weighted-Average Capital, Tanski
Number
Amount of Months Weighted
Invested Invested Dollars
$40,000 3 $120,000
Exercise 13-7, Concluded
Note B: Calculation of Annual Bonus
Bonus When Income Is $168,000
Bonus (B) = 20% × (Net Income – Bonus)
1.20% B = 20% × $168,000
EXERCISE 13-8
1. Interest on capital is intended to reward those partners who have significant capital
investments in the partnership. In a capital intensive business, such as the proposed
company, capital is an important driver of income. To the extent that the capital invested by
2. Although mathematically more rigorous, the purpose of calculating a bonus on net income
after the bonus is to insure that a bonus is not being accrued on the bonus itself. If the
3. Drawing and capital is not the same thing although in combination, they represent total
capital. Generally a drawing account is used to record withdrawals of capital not
contributions of capital and/or the allocation of profits or losses. The use of a drawing
4. In its purest sense, a salary to a partner is considered as a component of the profit and loss
agreement. Obviously salaries reported as W-2 wages represent that portion of the
5. Although this is possible to do, normally the percentage allocation for profits and losses are
the same. Practically speaking, it would be unusual to think of a situation where a partner’s
6. A partnership is characterized by unlimited liability and the partners are personally liable,
jointly and severally. This would be the case if the erection component of the business were
7. If the attorney were a limited partner in a limited partnership, their obligation for partnership
8. Being a partner would expose the attorney to more potential risk than an outside lender of
capital. As a partner they could be held personally liable for the obligations of the
EXERCISE 13-9
(1)
Allocation of Profits Based on Alternative A
Assumed income level ........................... $500,000 $560,000 $600,000
Salary .................................................... $120,000 $120,000 $120,000
Interest (Note A) .................................... 5,500 5,500 5,500
Exercise 13-9, Continued
Cash Distributions
Date—End of Amount
Quarter 1 ............................................... $ 30,000
Quarter 2 ............................................... 30,000
Quarter 3 ............................................... 30,000
Note A: Amount Number of Weighted
Invested Months Invested Dollars
$100,000 3 $300,000
70,000 3 210,000
Allocation of Profits Based on Alternative B
Assumed income level ........................... $500,000 $560,000 $600,000
Salary .................................................... $ 96,000 $ 96,000 $ 96,000
Interest (Note B) .................................... 10,000 10,000 10,000
Cash Distributions
Date—End of Amount
Quarter 1 ............................................... $ —
Quarter 2 ............................................... 24,000
Quarter 3 ............................................... 24,000
Quarter 4 ............................................... 24,000
Quarter 1 next year ................................ 60,000
Exercise 13-9, Concluded
Note B: Amount Number of Weighted
Invested Months Invested Dollars
$100,000 12 $1,200,000
Weighted-average ......................... $100,000
Interest @ 10% .............................. 10,000
Allocation of Profits Based on Alternative C
Assumed income level ........................... $500,000 $560,000 $600,000
Salary .................................................... $ 80,000 $ 80,000 $ 80,000
Cash Distributions
Date—End of Amount
Quarter 1 ............................................... $ 20,000
Quarter 2 ............................................... 20,000
Quarter 3 ............................................... 20,000
(2) Summary of above calculations:
Alternative A Alternative B Alternative C
Combined most likely profit ................... $180,500 $161,000 $190,000
Net present value .................................. 143,479 124,556 152,184
An initial investment of $100,000 is required, regardless of which alternative is selected.
Therefore, this investment is ignored for purposes of selecting an alternative. Also, all
