Two People Are Starting A Small IT Firm They Come To You For

Two People Are Starting A Small It Firm They Come To You For Advice O

Two people are starting a small IT firm. They come to you for advice on how to form a partnership. They have listed 2 scenarios and are asking you how to make journal entries for each one of the following transactions:

Scenario 1:

  • Two partners, A and B, start a partnership. Partner A’s investment is as follows: Cash: $20,000, Inventory: $30,000, Accounts payable: $50,000, Computer equipment: $40,000, Accumulated depreciation: $20,000.
  • Partner B’s investment is: Cash: $10,000, Computer software: $20,000.

Scenario 2:

  • Two partners, Small and Big, form a partnership. Small invests $40,000, Big invests $60,000 for a total of $100,000 in capital.
  • They agree that profits will be allocated as follows: the first $20,000 based on capital balances; the next $30,000 based on service (Small gets $20,000, Big gets $10,000); any remaining profits are shared equally.
  • The partnership’s net income is $100,000.

Calculate Small’s and Big’s share of the net income and prepare the journal entry for this allocation.

Paper For Above instruction

The formation of a partnership involves multiple financial transactions, including initial contributions and profit-sharing arrangements. Accurate journal entries are crucial to accurately reflect the financial position and profit distribution among partners. In this paper, we analyze the journal entries for two distinct partnership scenarios involving initial investments and profit allocations, applying fundamental accounting principles to each case.

Scenario 1: Recording Initial Investment Contributions

In the first scenario, Partners A and B start a partnership with differing contributions. Partner A contributes cash, inventory, equipment, and has liabilities, whereas Partner B contributes cash and software. The key to recording these investments is to accurately capture the net worth of the partnership upon formation.

Partner A’s total assets contributed include cash of $20,000, inventory valued at $30,000, and computer equipment worth $40,000. However, liabilities such as accounts payable of $50,000 and accumulated depreciation of $20,000 must be considered. The net book value of assets from Partner A is calculated as follows:

  • Total asset contribution: cash ($20,000) + inventory ($30,000) + computer equipment ($40,000) = $90,000.
  • Less liabilities: accounts payable ($50,000) + accumulated depreciation ($20,000) = $70,000.
  • Net contribution from Partner A: $90,000 - $70,000 = $20,000.

Partner B’s contributions include cash of $10,000 and software valued at $20,000, totaling $30,000.

The journal entries on formation should reflect the partners’ capital accounts and assets contributed:

Debit: Cash $30,000


Debit: Inventory $30,000


Debit: Computer Equipment $40,000


Credit: Accounts Payable $50,000


Credit: Partner A's Capital $20,000


Credit: Partner B's Capital $30,000

However, it's important to note that the actual journal entries depend on whether the assets are contributed at fair market value or book value, and whether liabilities are assumed by the partnership or paid off directly. In practice, the partnership would record these contributions at their fair values, and any discrepancies would be adjusted accordingly.

Scenario 2: Profit Sharing and Allocation

In the second scenario, the partnership begins with Small and Big investing $40,000 and $60,000 respectively, totaling $100,000. The profit-sharing arrangement involves complex allocations: first based on capital balances, second based on service, and finally equally among remaining profits.

Calculating Small’s and Big’s share of profits involves several steps:

Step 1: Allocate first $20,000 based on capital balances

  • Small’s Capital: $40,000
  • Big’s Capital: $60,000
  • Total Capital: $100,000
  • Ratio: Small = 40%, Big = 60%

Therefore, from the $20,000:

  • Small: 40% of $20,000 = $8,000
  • Big: 60% of $20,000 = $12,000

Step 2: Allocate next $30,000 based on service

  • Small: $20,000
  • Big: $10,000

Step 3: Allocate any remaining profit equally

Remaining profit after these allocations:

Total profit = $100,000

Already allocated: $20,000 + $30,000 = $50,000

Remaining: $50,000

Share equally:

  • Small: $25,000
  • Big: $25,000

Final allocation:

  • Small: $8,000 + $20,000 + $25,000 = $53,000
  • Big: $12,000 + $10,000 + $25,000 = $47,000

Thus, Small’s share of net income is $53,000, and Big’s share is $47,000.

The journal entry to record profit sharing would be:

Debit: Income Summary $100,000


Credit: Small’s Capital $53,000


Credit: Big’s Capital $47,000

This entry reduces income summary and increases partner capital accounts accordingly, reflecting their respective profit shares.

Conclusion

Accurately recording partnership formation and profit sharing requires understanding the contributions, liabilities, and agreement terms. The initial investments must be carefully journalized to reflect the assets and liabilities accurately. The profit-sharing arrangements should be computed based on the agreed-upon percentages and shared through journal entries impacting partner capital accounts. Proper accounting ensures transparency, fairness, and compliance with accounting standards, thereby fostering trust among partners and stakeholders.

References

  • Gibson, C. H. (2019). Financial Accounting (Spatial). Cengage Learning.
  • Weygandt, J. J., Kieso, D. E., & Kimmel, P. D. (2020). Financial Accounting, IFRS Edition. Wiley.
  • Horngren, C. T., Sundem, G. L., & Elliott, J. A. (2018). Introduction to Financial Accounting. Pearson.
  • Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2019). Financial Accounting Theory and Analysis: Text and Cases. Wiley.
  • Accounting Standards Codification (ASC) Topic 323, Investments—Equity Method and Joint Ventures. Financial Accounting Standards Board (FASB).
  • CPA Canada. (2021). Partnership accounting guide. CPA Canada Publications.
  • Harrison, W. T., & Horngren, C. T. (2021). Financial & Managerial Accounting. Pearson.
  • Block, S. B. (2018). Foundations of Financial Management. McGraw-Hill Education.
  • Meigs, W. L., & Meigs, R. F. (2019). Accounting Principles. McGraw-Hill Education.
  • IRS. (2022). Partnership taxation (Publication 541). Internal Revenue Service.

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