In this video, we walk through 5 FAR practice questions covering capital account activity in pass-through entities. These questions are from FAR content area 2 on the AICPA CPA exam blueprints: Select Balance Sheet Accounts.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Capital Account Activity in Pass-through Entities
In a pass-through entity like a partnership, each partner’s capital account tracks their equity in the business, reflecting contributions, withdrawals, profit allocations, and other adjustments. This guide will cover essential concepts for managing capital accounts in a pass-through entity, including calculating initial capital balances, using the bonus and goodwill methods for new admissions, applying interest based on capital, and handling profit and loss allocations. Each concept is demonstrated with examples to make these principles clear and practical.
Calculating Initial Capital Accounts
When a pass-through entity is established, each partner’s initial capital balance is recorded based on their contributions to the business. Contributions can include cash, property, equipment, or other assets. The capital balance is typically recorded at the fair market value (FMV) of the contribution, and any attached debt that the partnership assumes is subtracted.
Example:
Three partners, Anna, Ben, and Cara, form a partnership. They contribute the following:
- Anna: Cash of $50,000 and land with an FMV of $80,000, but with a $20,000 mortgage.
- Ben: Equipment with an FMV of $60,000.
- Cara: Inventory with an FMV of $40,000.
Anna’s capital balance would be her cash and land contribution minus the mortgage:
$50,000 + $80,000 – $20,000 = $110,000.
The initial capital accounts are recorded as:
- Anna: $110,000
- Ben: $60,000
- Cara: $40,000
Goodwill Method for Equalizing Capital Accounts
When forming a partnership, partners may agree to equal ownership despite unequal contributions. Using the goodwill method, the partnership recognizes goodwill to bring each partner’s capital account to the level of the highest contributor. This goodwill is recorded as an intangible asset.
Example:
Julia, Kevin, and Owen contribute $200,000, $150,000, and $100,000, respectively, and want equal one-third ownership. To achieve this balance, the partnership records goodwill to increase the capital accounts of Kevin and Owen to match Julia’s.
- Kevin’s goodwill: $200,000 – $150,000 = $50,000
- Owen’s goodwill: $200,000 – $100,000 = $100,000
The partnership will record $150,000 in goodwill, bringing each partner’s capital account to $200,000.
Bonus Method for Admitting a New Partner
The bonus method is used when a new partner contributes an amount that implies a different valuation of the partnership. If the new partner’s investment exceeds their implied share, a bonus is allocated from existing partners. Conversely, if it’s below the implied share, a bonus is added to the new partner’s account, reducing the existing partners’ balances.
Example:
Julia and Kevin have capital balances of $200,000 and $120,000, respectively, and agree to admit Owen, who contributes land valued at $85,000 with a $25,000 mortgage. Owen’s net contribution is $60,000. To give Owen a 20% interest, his capital needs to reflect 20% of the partnership’s total post-admission capital.
- Calculate total capital: $200,000 + $120,000 + $60,000 = $380,000.
- 20% of $380,000: $76,000.
Since Owen’s net contribution is $60,000, a $16,000 bonus is added to his capital account. Julia and Kevin contribute to this bonus proportionally from their accounts.
Applying Interest to Weighted Average Capital Balances
Partnership agreements often include interest on each partner’s capital based on a specified rate, calculated using the weighted average capital balance over the year. This method accounts for contributions and withdrawals throughout the year, ensuring that each partner’s interest reflects the actual average amount invested.
Example:
Logan and Mia have beginning capital balances of $200,000 and $150,000, respectively, and receive interest at 6% annually on their weighted average capital.
Logan’s capital changes:
- April 1: Contributes $50,000 (balance becomes $250,000).
- September 1: Withdraws $30,000 (balance becomes $220,000).
Weighted average for Logan:
(200,000 × 3/12) + (250,000 × 5/12) + (220,000 × 4/12) = 227,500
Interest for Logan:
$227,500 × 6% = $13,650
Profit and Loss Allocation after Interest Adjustments
After calculating interest on each partner’s capital, the remaining profit or loss is divided based on the partnership’s profit-sharing agreement. If the partnership income is less than the interest owed, the shortfall is treated as a loss and allocated accordingly.
Example:
In a year with $15,000 profit, total interest allocations exceed the profit, creating a shortfall. The shortfall is then shared as a loss among partners, reducing their ending capital balances.
Conclusion
Understanding how capital accounts function in a pass-through entity is key to managing partnership finances effectively. By applying these principles—calculating initial balances, using the goodwill and bonus methods, adjusting for interest on weighted capital, and allocating profits or losses—you can accurately reflect each partner’s share and make informed financial decisions.
