Problem 3 - Accounting

Question

Candace Hassell and Abby Lawson formed a partnership, investing \(\$ 240,000\) and \(\$ 80,000\), respectively. Determine their participation in the year's net income of \(\$ 200,000\) under each of the following independent assumptions: (a) no agreement concerning division of net income; (b) divided in the ratio of original capital investment; (c) interest at the rate of \(15 \%\) allowed on original investments and the remainder divided in the ratio of \(2: 3\); (d) salary allowances of \(\$ 50,000\) and \(\$ 70,000\), respectively, and the balance divided equally; (e) allowance of interest at the rate of \(15 \%\) on original investments, salary allowances of \(\$ 50,000\) and \(\$ 70,000\), respectively, and the remainder divided equally.

Step-by-Step Solution

Answer

(a) $100,000 each; (b) Candace $150,000, Abby $50,000; (c) Candace $96,800, Abby $103,200; (d) Candace $90,000, Abby $110,000; (e) Candace $102,000, Abby $98,000.

Step 1: No Agreement on Division

When there is no agreement concerning the division of net income, it is assumed that the profits are shared equally. Therefore, the net income of \( \\(200,000 \) will be divided between Candace and Abby equally. \[ \text{Candace's Share} = \frac{200,000}{2} = \\)100,000 \]\[ \text{Abby's Share} = \frac{200,000}{2} = \$100,000 \]

Step 2: Division by Capital Investment Ratio

The division is based on their original capital investments. The ratio of Candace's and Abby's investments is \( 240,000 : 80,000 \) which simplifies to \( 3:1 \). Net income is divided in this ratio.\[ \text{Candace’s Share} = \frac{3}{3+1} \times 200,000 = \frac{3}{4} \times 200,000 = \\(150,000 \]\[ \text{Abby’s Share} = \frac{1}{3+1} \times 200,000 = \frac{1}{4} \times 200,000 = \\)50,000 \]

Step 3: Division with Interest and Fixed Ratio

Calculate 15% interest on the original investments. Then divide the remainder of the profit in the ratio 2:3.Interest:\[ \text{Candace's Interest} = 0.15 \times 240,000 = \\(36,000 \]\[ \text{Abby's Interest} = 0.15 \times 80,000 = \\)12,000 \]Remaining Profit:\[ \text{Remaining Profit} = 200,000 - (36,000 + 12,000) = 152,000 \]Division in 2:3 ratio:\[ \text{Candace’s Remaining Share} = \frac{2}{2+3} \times 152,000 = \frac{2}{5} \times 152,000 = \\(60,800 \]\[ \text{Abby’s Remaining Share} = \frac{3}{2+3} \times 152,000 = \frac{3}{5} \times 152,000 = \\)91,200 \]Final Shares:\[ \text{Candace's Total} = 36,000 + 60,800 = \\(96,800 \]\[ \text{Abby's Total} = 12,000 + 91,200 = \\)103,200 \]

Step 4: Division with Salary Allowances

Allocate salary allowances first and then divide the remaining profit equally.Salary Allowances:\[ \text{Candace’s Salary} = \\(50,000 \]\[ \text{Abby’s Salary} = \\)70,000 \]Remaining Profit:\[ \text{Remaining Profit} = 200,000 - (50,000 + 70,000) = 80,000 \]Equal Division of Remaining Profit:\[ \text{Candace’s Share of Remainder} = \frac{80,000}{2} = \\(40,000 \]\[ \text{Abby’s Share of Remainder} = \frac{80,000}{2} = \\)40,000 \]Final Shares:\[ \text{Candace's Total} = 50,000 + 40,000 = \\(90,000 \]\[ \text{Abby's Total} = 70,000 + 40,000 = \\)110,000 \]

Step 5: Combination of Interest, Salaries, and Equal Division

First calculate 15% interest on investments, then allocate salary allowances. Divide any remaining profit equally.Interest:\[ \text{Candace's Interest} = 0.15 \times 240,000 = \\(36,000 \]\[ \text{Abby's Interest} = 0.15 \times 80,000 = \\)12,000 \]Salary Allowances:\[ \text{Candace's Salary} = \\(50,000 \]\[ \text{Abby's Salary} = \\)70,000 \]Remaining Profit:\[ \text{Total Allocated before Remainder} = 36,000 + 12,000 + 50,000 + 70,000 = 168,000 \]\[ \text{Remaining Profit} = 200,000 - 168,000 = 32,000 \]Equal Division of Remaining Profit:\[ \text{Candace’s Share of Remainder} = \frac{32,000}{2} = \\(16,000 \]\[ \text{Abby’s Share of Remainder} = \frac{32,000}{2} = \\)16,000 \]Final Shares:\[ \text{Candace's Total} = 36,000 + 50,000 + 16,000 = \\(102,000 \]\[ \text{Abby's Total} = 12,000 + 70,000 + 16,000 = \\)98,000 \]

Key Concepts

Profit Distribution

In partnership accounting, profit distribution refers to how the net income of a partnership is divided among partners. It is crucial to agree on a method of allocation to ensure fairness and transparency. If no agreement is made, profits are typically shared equally.
The aim is to align the distribution with each partner's input, such as their capital contribution, effort, or role in the partnership. This concept is important because it can affect partners' satisfaction and motivation, ultimately impacting the partnership's success.

Capital Investment Ratio

When partners invest different amounts of capital into a business, it's common to distribute profits based on the capital investment ratio.
This ratio reflects each partner's financial contribution to forming the partnership. For example, if one partner invests three times as much as another, they may receive a proportionately larger share of the profits. To calculate this, determine the ratio by dividing the investment amounts, simplify the ratio, and then apply it to the net income. This method ensures that partners are rewarded in line with their initial financial investment, promoting equity within the business.

Salary Allowances

Salary allowances are predetermined amounts that partners can receive as compensation for their work in the partnership. This approach recognizes partners' roles and responsibilities, differentiating between capital invested and efforts made. To calculate the distribution, first allocate the agreed salary allowances to each partner. Afterward, any remaining profit is shared according to an agreed method, often split equally or based on another specified ratio. Salary allowances are especially useful when partners contribute significantly different amounts of time or expertise. They ensure that effort and involvement are acknowledged financially, which aids in maintaining commitment and morale.

Interest on Investments

Interest on investments involves providing partners with a return on their initial capital contributions before distributing remaining profits. This method is another way to reward partners proportional to their financial risk. To implement this, calculate interest at the agreed rate (for instance, 15%) on each partner's initial investment. Deduct this interest from the total profit, and then distribute any remaining profit using a chosen method, such as equally or via a separate ratio. This approach ensures that partners are compensated for the opportunity cost of investing their capital into the partnership. It is an incentive to encourage investment and financial commitment within the partnership.