 Hello, and welcome to this session. This is Professor Farhat. In this session, we would look at partnership and specifically admission of a new partner. This is part three of five. This topic is covered in advanced accounting, and obviously it's covered on the CPA exam. Now, I would really like to connect with my viewers, so please connect with me on LinkedIn. I'm very active on LinkedIn. I always post additional lectures, tips for the exam, so on and so forth. If you're a Facebook user, you could go to my Facebook page accounting lectures, or definitely, I want you to connect with me on YouTube by subscribing, because this is where I post all my new lectures, as well as my Twitter account, and my website is farhatlectures.com. Let's go ahead and record changes in ownership and membership in a partnership. There are two methods that are frequently used. One method is called the bonus methods. When we accept a new partner, we use the bonus method, and what does the bonus method implies? It implies that assets are increased by the amount of the asset invested by the partner being admitted. What's going to happen? We're going to have more assets. Of course, we're going to have more assets, and any difference between the asset invested and credited in new partner accounts capital is adjusted to the capital account of the other partners. I'm going to just give you some numbers real quick, but we're going to work on this more specific example. Let's assume we have a new partner and that new partner invested $100,000. That's how much they invested. What's going to end up happening? We're only going to give them $80,000 in capital. Hold on a second. Didn't you say they invested $100,000? Yes, they did, but we're going to only give them $80,000. Take it or leave it. What does that mean? It means there's $20,000, $20,000, and that additional $20,000, it's going to go to the other partners, to the other capital account. The whole amount goes to the partnership, but the capital account of the other partner increases, or this partner invested $100,000, but we're going to give them $120,000 in capital. Why? Because we're so desperate for money and desperate for this individual. We want to attract them. Therefore, we gave them more capital than they invested. Then it's going to be taken away from the existing partner. This is the bonus method. Again, we'll work an example. Don't worry about it. The other method that we're going to be, that we could use is called the goodwill method. What is, how do we do this under the goodwill method? Under the goodwill method, under the goodwill method, a new asset is recorded that's based on the difference. So the new asset is recorded based on the difference between the value implied by the amount of the consideration and the value reported in the partnership box. So simply put, what's going to happen when somebody contribute money to us? What's going to happen? We're going to have to find out how much is the value of the, of the partnership worth. How does that work? Well, here's how it works. If somebody contributed $50,000, oops, $50,000, and we said, we are going to give you, we are going to give you 20% of the partnership for that money. Well, what does that mean? It means we are implying, if we take $50,000 divided by .2, we are implying that the partnership is worth $250,000. So we're going to find how much is the partnership worth? Then based on that, we're going to back into the journal entry. So just know that we're going to have to find the implied value. If somebody paid $50,000 and we gave them 20%, it means the partnership is worth $200,000 and $50,000. Sorry. And if you watch a show called a Shark Tank, I'm sure you do on CNBC. So when a new entrepreneur comes in and they would say, I will give you, if you give me $100,000, I'll give you 20% of my business. And immediately with this, what these people do, they grab their calculators and they take $100,000 divided by 20% to find out what? To find out how much does this individual value in your business? So if we take $100,000 divided by .2, the business is worth half a million. So this is how they start the negotiation. They say, well, is your business really worth half a million? Because that's what you're telling us. You're telling us your business is worth half a million. So we're finding the implied value. So the best way to illustrate this is to work examples. And we're just going to start with the very simple examples then build up. We have two partners, Phil and Tim, our partners in an electrical repair business. The respective capital balances, $90,000 for Phil, $50,000 for Tim. And they share profit and losses equally because the partners are confronted with personal financial problems. They decided to admit a new partner so they need money to the partnership. After an extensive interviewing process, they elected to admit Don into the partnership. Prepare the journal entry of the admission of Don under each of the following conditions. So we're going to have a different scenarios. The first scenario, we're going to assume that Don acquires bought one fourth, 25% of Phil's capital. Guess what? The partnership did not get anything, okay? And they paid Phil $30,000. So here's what's going to happen. This is Phil's capital. Phil's capital is $90,000. Phil's given up 25%. So Phil's given up $22,500. So Phil will reduce his capital by $22,500 and Don will be admitted and they will get $22,500. So simply put, the partnership did not benefit. The partnership as a business did not benefit. Basically, Phil gave up $22,500. It was replaced by Don. So notice, no cash is involved here. No cash for the partnership. Obviously, Phil took the cash and Phil deposited that cash in his personal account. But the partnership itself did not receive the cash. So notice this is basically a transaction. In terms of cash, it happened outside the partnership, but they had a partnership structure. Don acquired one fifth of each of Phil and Tim's capital. Now, Phil gave up 20%. Tom gave up 20%, which is 90,000 times 20% equal to 18,000. So Phil's capital will go down by 18. Tim's capital will go down by 10. And that's going to go to the new partner Don. So Don acquired the 28,000 of 18,000 coming from Phil, 10,000 coming from Tom. Notice this is outside the partnership. What do we mean by outside the partnership? The partnership did not receive a penny in these transactions. All what they do is they gave up some, they gave up their balances. So the partnership in a sense did not benefit. Now we're going to work where the new partner invests directly into the partnership. And this is, and we're going to be using the bonus method to account for this. Now, this is where the new partner, Don, invest in the partnership. Don acquires one fifth, which is 20%, one fifth capital interest for $60,000 cash investment. Total capital after the admission is 200,000. So here's what happened. We already have Phil with 90,000, Tim with 50,000. And now we have $60,000 in cash. So the total capital is 200,000. And what's going to happen? Don said that I am going to get 20% out of this. So he's going to get 20% out of this. So 20%, 20% out of 200,000 is 40,000. So notice Don paid 60,000. Don's getting 40,000. Why? Hey, look, if you want to invest with us, we're going to give you 40,000 for your 60,000, either take it or leave it. So basically what's going to happen, the new partners, because we're using the bonus method, they're going to get the bonus. So first, the partnership will receive $60,000 in cash. So this transaction involved the partnership itself. Don will get 40,000 in capital because this is how much based on the computation they're going to give them. Now, what about the additional $20,000 that Don invested? It's going to go to the capital account of Phil and Tim, 50,50. So Phil and Tim will split that additional capital as a bonus to their account, 50,50. So this is the bonus method. Now, let's assume we're going to be using the goodwill method. So Don invests $40,000 for one-fifth of the business. Now, here's what's going to happen here. First, we have to find out how much is the partnership worth. If Don invested $40,000 and we gave Don 20%, it means we are implying that the partnership is worth 200,000. Okay, let's do this. So we are implying that the partnership is worth 200,000. Now we can compute this. Phil's account is 90. Tim's account is 50. What's left is, which is 90 plus 40, 90 plus 50 equal to 140. Plus, we're going to give Don 40. So what's left is the $20,000 goodwill because it's supposed to be 200,000. If Phil has 90,000 balance, Tim, $40,000 balance and we're giving Don only 40,000 because that's what they said. We're going to give them 40,000. What's going to happen? We have 20,000 left and that's 20,000 is the goodwill. So let's go ahead and generalize the goodwill. So Don invested $40,000 cash and Don got $40,000 in the business. Now, as a result of this transaction, we find out that our company is worth more because what happened is the company only had, from a business perspective, here's what happened. From a business perspective, from a business perspective, the company was worth before Don 140,000, the 90 plus the 50. If Don contributed 40,000, then the business would have been 180. But what we said is when Don contributed $40,000, we sold him the $40,000 on a 20% discount basically. So the company is worth 200,000. So we revalued the partnership. The partnership is worth more than 180. The partnership actually is worth 200,000. So as a result, what's going to happen because the partnership is worth more and we know this because somebody was willing to invest with us, we're going to record an asset called goodwill and we are going to increase the existing partners' capital balances by 10,000. Why did we do so? Because somebody said your company is worth more than what it is. And because of this extra more, the existing partner, they get basically increase in their capital. So let's summarize. So acquisition of an interest by an investing asset. If the fair value of the asset invested equal to the book value of the capital asset acquired, there is no goodwill and bonus. So somebody invested $10,000. We gave them $10,000 in capital. There is no bonus. There is no goodwill. If somebody invested $10,000 in a business and we gave them only $8,000 in capital, then we have $2,000 going to the existing partners. So there's a bonus to the existing partners or a bonus or a goodwill to the company. If the person invested $10,000 and we gave them $12,000, we gave them more for their book value, then the additional $2,000 goes to the new partner. And we'll see an example. Okay. So if somebody is getting more than what they paid for, they will get a bonus. If somebody get less what they paid for, the bonus goes to the other partners. Okay. And the best way is to work through a series of examples. We have B, S and L, Beth, Steph, and Linda have been operating a small gift shop for several years. The partners concluded that the business needed to expand in order to provide an adequate return to the partners. The following balance sheet is for the partnership prior to the admission of the new partner, Mary. So they want to accept Mary, but this is what their position looks like. Cash $160, other assets $640, total assets of $800,000. They have liabilities of $200,000 and this is their capital balance. Beth right now own 40%, Steph own 40% and Linda owns 20%. Okay. But they want to admit Mary into the partnership. So we're going to work a few examples to show you how Mary is admitted and how do we account for that transaction. Under the first scenario, prepare the journal entry to record the admission of Mary assuming one. Mary is to invest sufficient cash to receive one sixth of capital interest. So Mary to receive one sixth of the interest. Right now, the total existing capital is $600,000. Okay. Now, what we're saying is when Mary is added, Mary is added based on, based on, not based on, she's going to be owning one sixth of the partnership, one sixth of the partnership. But we don't know how much she's invested, but she's going to be getting one sixth. Well, what does that mean? It means $600,000 that represent right now only five, six of the company. So the $600,000 represent five, six. So simply put, the company should be worth $720,000 after Mary invest. Okay. So how much Mary would need to invest? Well, if the company should be worth $700,000 and the capital balances should be $720,000 and right now it's $600,000 for Mary to get one sixth, she will need to invest $120,000. Simply put, if you take now $720,000 multiplied by $16,000, it's going to be $120,000. Okay. So basically Mary is, Mary is, is, is getting six, one 16th of the company. One more time. But first we needed to find out how much is the company's worth. So one divided by six equal to 16% times $720,000. And Mary will need to invest $120,000 to receive one sixth of the business. So that's the deal. You invest one 20 will give you one six. Right now, the company is worth based on your admission $720,000. Okay. Let's take a look at, so let's look at the journal entry. The journal entry will debit cash, credit Mary's capital $120,000. This is what actually happened. There's really no goodwill, nothing. Just we told Mary, you, you get one six and we computed how much that one six is worth. Now, prepared. This is a different scenario. Prepare the journal entry to record the admission of Mary assuming Mary is to invest $160,000 for one fifth of the capital. Now, Mary's going to invest $160,000 and get one fifth. Now let's take a look at this. Well, let me do it for you first. Beth, well, let's look at it anyhow. It doesn't matter. Beth has $265,000, Stath is $215,000, Linda is $160,000 and now we're going to add Mary's capital. Mary's capital is $160,000. So the total capital invested will be $760,000. Okay. After Mary invests $160,000. Mary is to receive 20% ownership interest. Well, if we take $720,000 and give Mary 20% of the current of the new capital, she would receive $152,000. So Mary spent $150,000. We gave her $152,000 in capital. We have $8,000 bonus, basically. What is that bonus going to go? That bonus is going to go to Beth, Stath and Linda. How is it going to go? Well, remember, they're 40, 40 and 20. So here's the journal entry. We debit cash 160. The partnership received actual cash 160. Mary's capital only increased by $152,000, although she paid 160, but if you want to join us, you're going to have to get less than what you paid for. And the 8,000 is split 40 to Beth, 40 to Stath and 22 Linda. So that's how it works. Okay. Let's assume in the same, again, one fifth, and now we're going to be assuming we're going to be using the goodwill method. How does the goodwill method works? Well, if we're saying Mary is investing 160,000 and we are saying Mary is to get 20%, now we're going to value the company. We're going to value the company, the partnership. And what we say is this. Okay. What we're saying is 160 divided by .2. We're saying the company is worth $800,000. Okay. This is the total implied capital. How much the capital should be? Well, how much is the total invested capital? Well, the total invested capital is this. After Mary invests 160, when it's added to everyone, the total invested capital is 760 right here from the prior computation. Well, and now the company is worth 800,000. It means there are $40,000 goodwill. Again, the 760 is what Beth balance is Linda, Beth, Linda and Steph and add Mary to them. Okay. But the company is worth 800,000 because Mary was paying get only 20% of 160, which is make the company worth 800,000. So there's a goodwill of $40,000. Obviously, what do we need to do? We need to record the journal entry. We debit goodwill credit, Beth account 16,000 credit Steph account 16,000 and credit Linda's account. So the goodwill went to the existing partner. Now, obviously, Mary is going to get 160,000 for her new capital. Okay. So this is a goodwill example. We work the same thing with a bonus example. Now, prepare the journal entries assuming three. Mary is to invest 160,000 for one fourth capital interest. So now we're going to be using the bonus method and Mary is to receive one fourth, which is 25%. Let's see what happened now. After Mary added her money in, the total capital invested should be 760. Now, if we give her, if we give Mary 25%, Mary will get 990,000. Here we are desperate for Mary. We want Mary to join the partnership. So Mary paid 160 in cash. Mary received 190 in capital. So Mary received a $30,000 bonus capital. So who's going to pay for that bonus? Not pay. Who's going to give up their capital accounts? Well, the other three. The other three will have to give up in total of 30,000 in relationship to their current ownership, 40, 40 and 20. So here's what's going to happen. Mary invested 160. Mary is to get 190. What happened to the other 30,000? Beth will give up 12,000. Staff will give up 12,000. And Linda will give up 6,000. 40%, 40% and 20%, multiplying by 30,000. Let's compute this using the Goodwill method. If Mary is to invest 160 for one fourth capital, well, one fourth means right now, right now, the current capital for the company is 600,000. Okay. The current capital is 600,000. How did I know it's 600,000? Well, right now, if you add up those three, they're up to 600,000. So this is how I know it's 600,000. And now we are going to give Mary one fourth. We're going to give Mary 25%. That means the 600,000 represents 75% of the company. What is 600,000? What's 600,000 divided by 600,000 divided by 0.75 equal to 800,000. We are implying the company is worth 800,000. Okay. But the invested capital is only 760 after Mary invests her money. So we have a Goodwill of 40,000. Oh, let's, let's journalize the entry. We're going to debit cash 160. We're going to debit Goodwill, 40,000. And Mary in that situation would receive 200,000 in capital. But basically, Mary got all the, all the Goodwill. Basically, Mary got all the Goodwill because she got one fourth of the company. So she received more than what, what she contributed. Okay. So hopefully this will, this, this, this illustration will help you understand how we, how we, how we, how we account for transaction. So notice the other partners here just going to let you know, did not reduce their capital. Basically, all the, all the, all the new, all the 40,000 went to, went to, went to Mary. So there is no reduction in their capital balances in contrast to the bonus method in contrast to the bonus method where their capital was reduced. Just so this is just for you to pay attention to. If you have any questions, any comments by all means email me. If you're studying for the CPA exam by all means study hard, make sure to visit my website for additional lectures. If you happen to visit, please consider donating. Thank you. Study hard. It's worth it.