ACFAR PREFINAL: CHAPTER 13 because if such were not the case, there would be no

partnership
PARTNERSHIP OPERATIONS
Now the question that arises is: “How will the partners
Introduction
divide the profits or losses resulting from the operation of
The operations of a partnership are similar in most the partnership?”
respects to those of other forms of organizations
The Partnership Law provides that if the profit has been
operating in the same line of business. At the end of each
agreed upon, the share of each partner in the losses
fiscal year, when revenues and expenses are closed out,
shall be in the same proportion with the net income
some assignments must be made of the resulting income
allocation. It also provides that in the absence of
figure because a partnership will have two or more
agreement, the share of each partner in the profits and
capital accounts rather than a single retained earnings
losses shall be in proportion to what they have
balance. This allocation to the capital accounts is based
contributed (based on capital contribution), but the
on the agreement established by the partners preferably
industrial partner shall receive such share as may be just
as a part of the Articles of Partnership.
and equitable under the circumstances.
A wide range of profit allocation is found in the business
However, the law is not clear as to what capital balances
world. Some partnerships have straightforward
shall be applied, whether the capital balances refers to
distribution plans while others have extremely complex
original capital, beginning or end of each period or the
ones. It is the accountant’s responsibility to distribute the
average capital during the period. In as much as the law
profit or loss according to the partnership agreement
does not clearly specify the capital balance, it is
regardless of how simple or complex that agreement is.
therefore, presumed to be the original capital, in the
Profit distributions are similar to dividends for a
absence of such original capital it should be the
corporation.
beginning capital.
Accounting for Partnership Operations: Methods to
The reason behind the usage of original capital (in his
Allocate Net Income or Loss
absence, the beginning capital) is that, if at the time of
In measuring partnership profit for a period, expenses formation there is no agreement, the law should apply
should be scrutinized to make sure that partners’ and the only available capital balance is the original
personal expenses are excluded from the partnership’s capital. Even though usage of original capital seems to be
business expenses. If personal expenses of a partner are unreasonable because of inequity, logic dictates that
paid with partnership assets, the payment is charged to profit and loss should be established at the time of
the drawing or capital account of that partner. Drawings formation due to some of the following reasons:
are closed to the capital accounts of the partners rather
1. Subsequent adjustments in assets and
to an income summary account.
liabilities;
Practically all partnerships have a profit or loss
2. Admission of a new partner;
allocation agreement. It would be rare to find a
partnership that did not spell out the divisions of profits 3. Retirement or withdrawal of a partner;
or losses in details. The agreement must be followed and
precisely, and if it is unclear, the accountant should make
4. Liquidation of partnership.
sure that all partners agree to the profit or loss
distribution. Partners should select a formula that is All of the above reasons require the use of profit and
sensible, practical, and equitable. The formula used to loss ratio. The wait period for the end-of-the-year
divide profits and losses is determined through balances to determine the average or ending capital
negotiations among the partners. Whether it is fair or would be in exercise of futility because of the urgency of
not, it does not concern the accountant. profit and loss ratio. Deferral of such action would not
address the above reasons.
It is necessary that the benefit the partners expect to
obtain from the combination of their respective In the United States, in the absence of any agreement,
contribution should be common to all the partners, profit or loss should be allocated equally and if they
agreed on capital balances it is presumed to be the Equally
average capital. Nevertheless, these are practices which
This method may be proper when the capital or service
are not applicable under Philippine setting because of its
contribution of the partners are considered to be the
differing law provisions.
same.
Profits and loss can be shared in many ways among
The entry of the partnership of X and Y to record the
partners of a partnership. Most profit and loss sharing
allocation of net income of P288,000 equally would be as
formula includes one or more of the following features or
follows:
techniques:

1. Equally;
2. Arbitrary ratio;
3. In the ratio of partner’s capital account balances
and the dividing the balance on agreed ratio:
a. Original capital – the initial investment / The resulting balances in the drawing accounts may be
capital at the time of formation. closed into the capital accounts
b. Beginning capital of the period
Arbitrary Ratio
c. Average capital
When the capital and service contribution of the partners
c1. Simple average are unequal, an arbitrary profit ratio may be employed to
recognize these differences.
c2. Weighted average
c2.1. Peso-day approach An infrequently used variation of this method specifies
one ratio for profits and a different ratio for losses.
c2.2. Peso-month approach Because profit and loss years may alternate, it is
4. Interest on partners’ capital accounts and extremely important that profit or loss for each year be
dividing the balance on agreed ratio; determined accurately in all material respects when this
5. Salaries to partners and dividing the balance on variation is used.
agreed ratio;
Although agreements to share profits and losses equally
6. Bonus to partners and dividing the balance on
or in specified ratios are common, more complex profit
agreed ratio; and
7. Interest on capital account balance, salaries and sharing agreements are also encountered in practice. The
bonus to partners and dividing the balance on time that partners devote to the partnership business
agreed ratio and the capital contributed in the business by individual
partners are frequently considered in determining the
Illustration 18-1: Allocation of Net Income profit sharing agreement.
Assume that a net income of P288,000 is determined for Assume that, since the expertise, ability, and reputation
X and Y Partnership at the end of 20x4. Regular of X are factors of special significance to the success of
withdrawals by partners in anticipation of net income the partnership, X and Y agree to allocate net income in
have been summarized in the drawing accounts; the ratio of 3:2. The entry to record the allocation of net
permanent capital changes have been summarized in income of P288,000 is:
the capital accounts. Drawing and capital accounts at
the end of 20x4 appear as follows:
(288,000/3)5
(288,000/2)5
Capital Balances Average Capital. It must have provided the fairest basis
for allocating partnership profit because it reflects the
To avoid argument, it is essential that the partnership
capital actually available for use by the partnership
contract specifies whether the profit-sharing ratio is
during the year. An agreement for the use of average
based on (1) the original capital investments, (2) the
capitals also acts as an incentive for additional
beginning capital account balances at the beginning of
investments when these can be profitably employed.
each year, (3) the balances at the end of each year
(before the distribution of net income or loss), or (4) the If the partnership contract provides for sharing profit in
average balances during each year. the ratio of average capital account balances during the
year, it should also state the amount of drawings (refer
Original Capital. If the agreement between X and Y
to Chapter 19 for further discussion on drawing
provides that the allocation of net income shall be based
accounts) each partner may make without affecting the
upon original capitals, reference would be made to the
capital account. Any additional withdrawals or
amounts originally invested by the partners.
investments are entered directly on partners’ capital
Beginning Capital. When beginning capital balances are accounts and therefore influence the computation of
used in allocating partnership profit, additional average capital ratio.
investments during the accounting period may be
The following guidelines should be considered:
discouraged because the partners making such
investments are not compensated in the division of profit • An agreement should indicate clearly
until a later period. Usage of this will prove to be what withdrawals or drawings
inequitable. Assuming this agreement for X and Y, the accounts are to be recognized;
entry to record the allocation of net income of P288,000
• A partnership agreement may state that
for the year is:
only withdrawals above a certain limit
are to be viewed as offsets (reduction)
against capital balances. It means that
drawing account balances up to the
amounts specified in the agreement
would not be deducted in determining
the partners’ average or year-end capital
balances.

Ending Capital. A similar problem exists when ending • Typically, either personal withdrawals
capital balances are used. Year-end investments are or temporary withdrawals or drawing
encouraged by their inclusion in determining each accounts (which are withdrawal against
partner’s share of profit, but no incentive exists for a share in anticipated profit) are not
partner to make any investments before year-end. recognized in the computation of
average capital. Conversely, capital
Also, no penalty exists for withdrawals if the amounts
withdrawals or permanent withdrawals
withdrawn are reinvested before the period’s end. If the
(which are withdrawal against original
partnership agreement provides for an allocation of net
or additional investments) are
income based upon partner’s capital at the end of each
recognized.
year, the entry to record the allocation of net income of
P288,000 for the year is: The reason for the non-inclusion of the personal
withdrawals in the computation of average capital is that
in as much as profits are generated evenly throughout
the year, the figure itself is already an average amount.
Mathematically, the resulting figure of inclusion of such
withdrawals or excluded in the average capital
computation is exactly the same
The average capital balances for the year can be The purpose of allowing interest on capital is to give
computed using the following approach: recognition to differences on capital contributions by
partners. It also recognizes the contribution of the
1. Simple average. This method is not so
partners’ capital contribution to the partnership’s
widely used by accountants in view of its
profit-generating-capacity. The use of interest on
failure to take into consideration the
capital as a means of allocating profits would be
periods of time the changes in capital
appropriate when the business is capital intensive
take place
versus labor intensive or if the partners were not
2. Weighted average. The partners may significantly involved in the day-to-day operations.
wish to recognize all the changes in their
Interest on Capital as a Distribution/Allocation of Net
capital as well as in their drawing
Income. Using interest allowances on partners’ capital
accounts in determining the capital ratio
accounts as a technique for sharing partnership profit
to be used in distributing the profits or
equitably has no effect on the measurement of net
losses in the operation of the
income or loss of the partnership.
partnership. The partnership contract
should state whether weighted capital Remember that the partners’ capital contributions are
account balances are to be computed to just that – they are not loans to the partnership.
the nearest day (using daily Accordingly, it is not appropriate to charge an Interest
balances/peso-day approach) or to the Expense account and an Interest Payable account,
nearest month (beginning-of-month because interest on partner’s capital account is not an
balances or end-of-month expense of the partnership.
balances/peso-month approach.)
Assume that X and Y agree to allow interest on average
For peso-month approach, investments and withdrawals capital at 6%; any net income or loss balance is to be
made at the beginning of the month if made before the allocated 3:7. Assuming no entries for interest during the
middle of the month and are to be considered as made course of the year, entries to record the allowance of
at the beginning of the following month if made after the interest and the remaining allocation of net income
middle of the month. follow:

If the allocation of net income is to be based upon

average (weighted) capitals for the year, the entry to
record the allocation of net income of P288,000 for the
year is:

(243,000/10)3
(243,000/10)7

The allocation of net income may be summarized in a

single entry as follows:

Interest on Capital Accounts with Resultant Net Loss

If the partnership contract provides for allowing interest

Interest on Capital Balances on capital accounts, this provision must be enforced
regardless of whether operations are profitable or
unprofitable.

The only justification for omitting the allowance of

interest on partners’ capital accounts during a loss year
would be in the case of a partnership contract containing
a specific provision requiring such omission. After the The net effect of the foregoing on capitals is:
entry for interest in such a case, the debit balance in the
income summary account is transferred to the partners’
drawing accounts in the profit-and-loss ratio.

In case of loss, the interest allowed to the partners shall

be added to the net loss and the total resulting loss shall The allocation of net income may be summarized in a
be distributed in the ratio agreed upon by the partners single entry as follows:
for the distribution of the balance after allowance of
interest.

For example, assume that operations for X and Y prior to

Interest on temporary advances or loans. When a
the recognition of interest had resulted in a net loss of
partnership makes a temporary advance to a partner or
P80,000 and any balance will be allocated into 1:4 ratio.
receives an amount as a temporary loan from a partner
Entries to close the income summary account would have and these transactions are recognized as creating
been as follows: debtor — creditor relationships between the partner
and the partnership, interest charges and credits on
such transactions are recognized as interest-expense-
interest-income.

Interest accruals are recognized periodically on these

items just as other receivable and payable balances.
When settlement for interest is made by cash, entries to
The net effect of the foregoing on capitals is: record the collection of interest or the payment of
interest are made in the usual manner.

When settlement is not to be made in cash but by

adjustments to partners’ capitals, interest on an advance
to a partner is recorded by a charge to the partner’s
The allocation of net income may be summarized in a drawing account and a credit to Interest Income, interest
single entry as follows: on a loan made by a partner to the partnership by a
charge to Interest Expense and a credit to the partner’s
drawing account.

In summary, interest on loans from partners is

Partners can provide by agreement that net income or recognized as expense and as a factor in the
loss shall be allocated in some arbitrary manner without
measurement of net income or loss of the partnership.
recognition of interest when the results from operations Similarly, interest earned on loans is recognized as
fail to cover a specified interest allowance.
partnership revenue. This is consistent with the principle
Interest on Excess Capital Balance. It may be agreed to that loans from partners are assets and liabilities,
allow interest on the excess of the average capital of one respectively.
partner over that of another. If these were the Personal Services Rendered in Net Income and Loss
agreement between X and Y, the entry to record interest
Sharing Agreements
and the balance in net income assuming 1:2 ratio is:
Partners may wish to provide for an allocation of net
income that recognizes differences in their abilities and
experience or in the time devoted by them to business.
Partners may agree to an arbitrary ratio for this purpose.

However, the use of an arbitrary ratio to recognize

personal differences is subject to the same limitations as
those found in the use of the capital ratio to recognize
capital differences; i.e., it may fail to provide satisfactory The net effect of the foregoing on capitals is:
recognition of the several factors contributing to the
success of the partnership and it may prove inequitable
in the event of loss when the partner who has made the
greater personal contribution to the partnership is
charged with the greater part of the loss The allocation of net income may be summarized in a
Salary Allowances single entry as follows:

In recognizing differences in personal contribution as

well as other factors that are responsible for the success
of the partnership, it may be agreed that partners shall
be allowed salaries, with any net income or loss balance
after salaries divided in some arbitrary ratio. Philippine Salary Allowances with Resultant Net Loss
partnership law makes no provision for remuneration for When an agreement provides for salaries without
partner’s services in the absence of an agreement, so it qualification, salary allocations must be made even
is up to the partners to agree on what is just and fair though profit is inadequate to cover salaries or there is
compensation. a loss. After salaries are recorded, the income summary
A partner who devotes time to the partnership business account shows a debit balance that is transferred to the
while the other partners work elsewhere may receive a partners’ accounts as agreed.
salary allowance. Salary allowances are also used to Bonuses
compensate for differences in the fair value of the
talents for partners, all of whom devote their time to the Bonuses are sometimes used as a means of providing
partnership. additional compensation to partners who have provided
services to the partnership. Bonuses are typically stated
The purpose of salary allowances are means of as a percentage of profit either before or after the bonus.
achieving a fair division of profit among the partners
based on the time and talents devoted to partnership In the absence of any agreed basis, bonus is computed
business. Salaries to partners are often included as part on the basis of partnership net income and the concept
of the profit distribution plan to recognize and of “partnership net income” is generally understood in
compensate for differing amounts of personal services accounting practice (i.e., before bonuses are deducted.)
partners provide to the business However, partnership agreement should be precise in
To illustrate the effect of a salary arrangement, assume specifying the measurement procedures to be used in
that X and Y agree to the allowance of monthly salaries determining the amount of the bonus.
of P10,000 and P9,000, respectively; any net income or As with interest on capitals and salary allowances, a
loss balance to be allocated in the ratio of beginning bonus should be considered as a distribution of profit and
capital. Amounts actually withdrawn by partners during not to be charged to an expense account.
the year were recorded in their drawing accounts as
presented in the original problem. The net income of Sometimes the partnership agreement requires a
P288,000 before recognition of salaries is allocated to the minimum profit to be earned before bonus is calculated.
partners by the following entries:
Illustration 18-2: Allocation of Net Income with Bonus. 1. Bonus is based on net income before bonus,
salaries and interest – same as Illustration 18-2
The net income of A and B Partnership for 20x4
(A)
amounted to P420,000. A, as the managing partner, is
allowed as a bonus based on the following assumptions:

A. A bonus of 20% of net income before the bonus

is deducted, the bonus would be computed as (216,000/3)2
(216,000/3)2
follows:
The schedule showing the allocation of net income is
presented as follows:

2. Bonus is based on net income after bonus but

before salaries and interest - same as Illustration
B. A bonus of 20% of net income after deduction of 18-2 (B).
the bonus, the bonus would be computed as
follows:

The schedule showing the allocation of net income is

presented as follows:

3. Bonus is based on net income after bonus and

As a general rule, when the partnership provides without salaries but before interest:
qualification that bonus is to be allowed, bonus should B= 20%(Net Income - Bonus - Salary)

be based on net income before deduction of bonus.

Basis of Computation for Bonus

As long as the basis of computation for bonus will be a

positive amount, the resulting bonus should always be
allocated to partners entitled to it, regardless of the Note: It should be noted that the term “before” used in
availability of the residual amount. the allocation of net income particularly in the
computation of bonus does not give any sense at all
Illustration 18-3: Allocation of Net Income with Bonus, because the general rule as to the interpretation of “net
Salaries, Interest and Income tax. income” means it is before deduction of bonus, salaries
Refer to Illustration 18-2, assume that the partners to partners and interests on capital. These three elements
further agreed on the allocation of net income: (bonus, salaries to partners and interest on capital) of
allocation of net income are not expenses of the
• Bonus of 20% to A; partnership but merely as a distribution or allocation of
net income
• Salaries to A, P40,000 and B, P60,000;
Proof:
• Interest on average capital balances – A,
P12,000 and B, P8,000.

• Residual balance in net income be

allocated to A and B in the ratio of 2:1
ratio
The schedule showing the allocation of net income is
The following assumptions for bonus are considered: presented as follows:
 Proof:

4. Bonus is based on net income after bonus,

salaries and interest: Bonus as computed above

Bonus with Resultant Net Loss

The concept of bonus is not applicable to a net loss.

Proof: When a partnership operates at a loss, the bonus
provision is disregarded because it defeats the purpose
of giving bonus.

Insufficient Income to Cover Allocation

In some cases, the partnership net income may be less

than the interest, salary and/or bonus provided for in
The schedule showing the allocation of net income is
the partnership agreement.
presented as follows:
If the partners fail to provide for such an occurrence in
the profit and loss formula, the established practice is to
allocate the interest, salary and/or bonus as if sufficient
income had been earned. The amount by which the
interest, salary and/or bonus exceeds the net income is
5. Bonus is based on net income after salaries but
allocated to the individual partners in their agreed ratio
before bonus and interest:
for allocating residual income.

Therefore, it is simply satisfying all provisions of the profit

and loss agreement. This procedure should also be
followed when the partnership has an overall loss (see
Refer to Note of No. 3. previous discussion on interest, salary and bonus with a
6. Bonus is based on net income after interest but resultant net loss).
before bonus and salaries: Special Problems in Allocation of Profit and Loss -
Salaries and Interest as an Expense

In the previous discussions, net income was viewed as

the return to the partners for their full contribution to
Refer to Note of No. 3 the business as owners – capital as well as personal
service. Interests and salary allowances to partners
7. Bonus is based on net income before bonus but were regarded as a means of providing for an equitable
after income tax (tax rate is 35%): distribution of such income.

It is possible to record salaries and interest as part of

expense items rather than as distribution or allocation
of net income.
Substituting the equation for T in the equation for B: When these items are made to expense accounts rather
than to the partners’ drawing accounts (or capital
accounts); expense balance are then closed into the
Income Summary account in arriving at the net income the first P40,000 of profit on the sale of that machinery
to be allocated in the agreed profit and loss ratio. is to be shared in the old profit and loss sharing ratio.

On the income statement, partners’ interest and salaries Under this method, the partnership avoids making an
would be listed with the other expenses in arriving at net entry that is different with what is Generally Accepted
income or loss of the partnership. Accounting Principles (GAAP). This is not a major reason
for selecting this alternative, however, if revaluing assets
Whether partners’ interest and salaries are treated in the
is more practical
accounts as expense items or as distributions or
allocation of net income, the eventual distribution or When the profit and loss sharing formula is revised, the
allocation of partnership net income or loss among the new formula should contain a provision specifying that
partners remain exactly the same. the old formula applies to certain types of subsequent
adjustments arising out of activities that took place
Corrections of Partnership Net Income of Prior Period
before the revision date. Examples are as follows:
Errors may occur in accounting for partnership
1. Unrecorded liabilities at the revision
operations, such as failure to accrue or defer expenses or
date;
revenue errors in the inventory count or pricing, or errors
in the calculation or amortization of assets. 2. Settlement on lawsuits not provided for
at the revision date, even though the
Problems in the allocation of profit and loss can result if
liability may not have been probable as
(1) errors are discovered that occurred in specific prior
to payment or reasonably estimate at
years, and (2) the partners have altered the profit and
that time;
loss agreement since the period in which the error
occurred. In corporation, an error correction is accounted 3. Write-offs of accounts receivable
for as an adjustment to the beginning retained earnings existing as of the revision date.
balance.
Regardless of the fact that some of these items do not
However, in a partnership the correction is allocated to qualify as prior period adjustments greater equity is
the individual partners’ capital accounts. The allocation usually achieved among the partners by using the old
should be based on the profit and loss agreement in sharing formula. Because partnerships need not follow
effect during the period of the error. GAAP, the will of the partners may prevail.

Subsequent Changes in Methods to Allocate Net Income Special Profit Allocation Methods
or Loss
Some partnerships distribute net income on the basis of
If the partners subsequently agree to change the method other criteria. For example, most public accounting
to allocate profit and losses, equity dictates that assets partnerships distribute profit:
be revalued to their current values at the time of the
1. On the basis of partnership “units”. A
change.
new partner may acquire a certain
For example, assume that partners X and Y shared profits number of units, and additional units are
and losses in a 6:4 ratio respectively, but at a later date assigned by a partnership compensation
agreed to share profits and losses equally. Suppose that committee for obtaining new clients, or
the partnership holds a piece of machinery carried on the for providing the firm with specific areas
books at P100,000, but with a P140,000 current value. of industrial expertise
Partner Y would receive a larger share of the profit on the
2. Performance methods. It gives some
machinery (when it is later sold) than had the machinery
weight to the specific performance of
been sold before the change in the method to share
each partner to provide incentives to
profits and losses were shared 6:4 ratio.
perform well. Some examples of the use
As an alternative to revaluing the machinery to its current of performance criteria are listed below:
value to stipulate in the new profit-sharing formula that
 a. Chargeable hours. These are the X and Y Partnership
total number of hours that a
Statement of Changes in Partner’s Capital Accounts
partner incurred on client-
related assignments. Weight For the Year Ended, December 31, 20x4
may be given to hours in excess
of normal.

b. Total billings. The total amount

billed to clients for work
performed and supervised by a
partner constitutes total billings.
Weight may be given to billings
in excess of normal

c. Write-offs. Write-offs consist of X and Y Partnership

the amount of uncollectible
Schedule – Allocation of Net Income
billings. Weight may be given to
a write-off percentage below For the Year Ended, December 31, 20x4
normal

d. Promotional and civic activities.

Time devoted to developing
future business and enhancing
the partnership name in the
community is considered
promotional and civic activity.
Weight may be given to time
spent in excess of normal or to Substituting the equation
for T in the Equation for B:
specific accomplishments
resulting in new clients
Let B = 84,000 -.20B - .20T
B= 84,000- .20 B - .20 (147,000)
e. Profits in excess of specified 1.20B= 84,000 - 29,400
level. Designated partners 1.20B= 54,600
B= 45,500
commonly receive a certain Proof
percentage of profits in excess of
a specified level of earnings Net Income Before Bonus and Income Tax. 420,000
Less: Bonus. 45,500
Statement of Changes in Partners’ Capital Accounts Net income after bonus before income tax. 374,500
Less: Income Tax (35% x 420,000). 147,000
Net Income After Bonus and Income Tax. 227,500
The balance sheet and income statement for a
partnership are accompanied by a third statement that Bonus as computed above

reports the changes that have taken place in the Net Income after bonus and income tax. 227,500
Multiplied by Bonus rate. 20%
partners’ interests during the period. The statement of Bonus. 45,500
changes in partners’ capital accounts based on
Illustration 18-1 (assuming that 6% interest is based on
average capital with the remaining net income be
allocated based on a 3:7 ratio for X and Y, respectively)
may be prepared in the following manner: