PROFELEC 1 (Review of Advanced Financial Accounting & Reporting)

MIDTERM PERIOD - A.Y. 2024-2025

Instr. Mike Glenard F. Cascante
PARTNERSHIP OPERATIONS
TYPES OF ACCOUNTING PROBLEMS
1. Division of Partnership profits and losses
2. Changes in the profit and loss ratios
3. Correction net income (loss) from prior years

DIVISION OF PROFITS AND LOSSES

General rule: Per partnership law, if no agreement on the division of profits and losses
among partners, it will be divided according to their original capital contributions.

If partners agree to divide profits only, the ratio shall also apply to partnership losses.
If however, partners agree to divide losses only, the general rule above shall apply.

Illustration: Mark and Felipe formed a partnership on January 1, 2021. On December 31, 2021,
the Income Summary account shows a credit balance of P150,000.00 with the Statement of Changes
in Partners' Equity presented as follows:

MF Partnership
Statement of Partners' Equity
December 31, 2021
Mark Felipe
Capital Balances, Jan 1 80,000.00 70,000.00
Additional Investments, April 1 20,000.00
Wihdrawal, June 1 - 15,000.00
Additional Investments, Oct 1 25,000.00
Wihdrawal, Nov 1 - 10,000.00
Capital Balances, Dec 31 90,000.00 80,000.00

Equal Distribution of Profits and Losses

Entry to record distribution of profits

Income summary 150,000.00
Mark, Capital 75,000.00
 Felipe, Capital 75,000.00

Entry to record if partnership incurred P20,000.00 loss.

Mark, Capital 10,000.00
Felipe, Capital 10,000.00
Income summary 20,000.00

Division of Profits and Losses in an unequal ratio

Entry to record distribution of P150,000.00 profits in the ratio of 70% to Mark and 30% to Felipe.
Income summary 150,000.00
Mark, Capital 105,000.00
Felipe, Capital 45,000.00

Division of Profits and Losses based on the ratio of Partners' Capital Account Balances
General rule: If partners agree to divide the partnership profits based on capital balances but fails
to specify how capital balances are to be computed, the average capital balances should be used.
If it can be computed, but if not, the original capital balances should be used.

Ratio of original capital contributions

Mark P150,000.00 * P80,000.00/P150,000.00 = 80,000.00

Felipe P150,000.00 * P70,000.00/P150,000.00 = 70,000.00

Entry to record distribution of P150,000.00 profits based on original capital contributions

Income summary 150,000.00
Mark, Capital 80,000.00
Felipe, Capital 70,000.00

Ratio of ending capital balances

Mark P150,000.00 * P90,000.00/P170,000.00 = 79,411.76

Felipe P150,000.00 * P80,000.00/P170,000.00 = 70,588.24

Entry to record distribution of P150,000.00 profits based on original capital contributions

Income summary 150,000.00
 Mark, Capital 79,411.76
Felipe, Capital 70,588.24

Ratio of average capital balances

Simple average method - uses the beginning and ending capital balances of each partners.
Mark (P80,000.00 + P90,000.00)/2 85000
Felipe (P70,000.00 + P80,000.00)/2 75000
Total 160000

Mark P150,000.00 * P85,000.00/P160,000.00 = 79,687.50

Felipe P150,000.00 * P75,000.00/P160,000.00 = 70,312.50

Peso month/Peso-day method- this method only considers amounts of withdrawals in excess
of the specified allowable drawing amounts.
For Peso-month, the computation of the average capital account balances
would be the capital balance plus additional investments minus withdrawals
for that particular month multiplied by the fraction of the number
of month/s counted up to the next capital balance movement over the 12 months.

Illustration:
MF Partnership
Computation of Average Capital Balances
Year Ended December 31, 2021

Partner Date Investment/ Capital Fraction of Average

Withdrawals Account Year Capital
Balances Unchanged Balances

Mark Jan 1 80,000.00 80,000.00 3/12 20,000.00

April 1 20,000.00 100,000.00 7/12 58,333.33
August 1 - - - -
Oct 1 - - - -
Nov 1 - 10,000.00 90,000.00 2/12 15,000.00
93,333.33
Felipe Jan 1 70,000.00 70,000.00 7/12 40,833.33
April 1 -
August 1 - 15,000.00 55,000.00 2/12 9,166.67
Oct 1 25,000.00 80,000.00 3/12 20,000.00
Nov 1 - - - -
70,000.00

Total average capital account balances 163,333.33

Distribution of profits based on average capital balances - peso month method:

Mark P150,000.00 * P???/P??? = ??? 85,714.29
Felipe P150,000.00 * P???/P??? = ??? 64,285.71

Peso-day method- this method is just like the peso-month but the difference is
when the additional investments/withdrawals fall on a specified day in the month but the process of'
computation is still the same. The common practice is to treat withdrawals/investments made during
the first half of the month as if they were made on the beginning of the month while those made on the
second half of the month will be treated as if they were made on the first day of the following month.

Illustration:
MF Partnership
Computation of Average Capital Balances
Year Ended December 31, 2021

Actual Date to be Investment/ Capital Fraction of Average

Date applied Withdrawals Account Year Capital
Balances Unchanged Balances

Mark Jan 2 Jan 1 80,000.00 80,000.00 4/12 26,666.67

April 16 May 1 20,000.00 100,000.00 6/12 50,000.00
Nov 13 Nov 1 - 10,000.00 90,000.00 2/12 15,000.00
91,666.67

Felipe Jan 2 Jan 1 70,000.00 70,000.00 7/12 40,833.33

August 5 Aug 1 - 15,000.00 55,000.00 3/12 13,750.00
Oct 27 Nov 1 25,000.00 80,000.00 2/12 13,333.33
 67,916.67

Total average capital account balances 159,583.33

Distribution of profits based on average capital balances - peso day method:

Mark P150,000.00 * P???/P??? = 86,161.88
Felipe P150,000.00 * P???/P??? = 63,838.12

Interest Allowed on Partners' Capital with Remaining Profit/Loss Divided in an agreed ratio
This allows the partners to encourage more capital investments by providing an interest based on their
capital contributions with specification on which method of determining the amount of capital balances .
Important note: This is not an expense of the partnership but only a part of fair division of profits/losses
among the partners based on the time and talents devoted to partnership business.

Illustration: Supposed the partners agree to provide 8% interest on both partners' average capital balances
and the partnership resulted to net income of P150,000.00 for the year. The remainder shall be divided equally.

Average Capital Balances

Mark 90,000.00
Felipe 70,000.00

Schedule of Profit Distribution

Mark Felipe Total
Interest on average capital:
Mark (P90,000.00*8%) 7,200.00 7,200.00
Felipe (P70,000.00*8%) 5,600.00 5,600.00
Remainder 68,600.00 68,600.00 137,200.00
Totals 75,800.00 74,200.00 150,000.00

Illustration: Supposed the partners agree to provide 8% interest on both partners' average capital balances
and the partnership resulted to a net loss of P30,000.00 for the year. The remainder shall be divided equally.

Schedule of Loss Distribution

Mark Felipe Total
Mark (P90,000.00*8%) 7,200.00 7,200.00
Felipe (P70,000.00*8%) 5,600.00 5,600.00
Remainder - 21,400.00 - 21,400.00 - 42,800.00 (squeezed amount)
Totals - 14,200.00 - 15,800.00 - 30,000.00

Salary and Bonus Allowances

Like Interest allowed to capital account balances, providing salaries is one of the methods of fairly
dividing the profits among partners with significant contribution to the business while bonuses
are provided to managing partners to encourage profit maximization.
However, bonus is not applicable if the operation result to a net loss.

Illustration: Supposed the partners agree to provide 8% interest on both partners' average capital balances, salaries of
P25,000.00 to Mark and P30,000.00 to Felipe, and the partnership resulted to net income of P150,000.00 for the year.
Furthermore, a bonus of 10% of net income shall be given to Felipe as managing partner while the remainder shall be
divided equally.
Average Capital Balances
Mark 90,000.00
Felipe 70,000.00
Case 1. Net income before allowances for salaries, interest and bonus.
Under this method, bonus is not treated as expense but only a tool in dividing the profits.
Mark Felipe Total
Salary allowances 25,000.00 30,000.00 55,000.00
Interest allowances 7,200.00 5,600.00 12,800.00
Bonus to Felipe 15,000.00 15,000.00
Remainder, equally 33,600.00 33,600.00 67,200.00 (squeezed amount)
Totals 65,800.00 84,200.00 150,000.00

Case 2. Net income before allowances for salaries, interest but after deduction of bonus.
Under this method, the bonus to Felipe is treated as an expense.

Equation would be : Bonus + Income after bonus = P150,000.00

Let X = income after bonus
0.1X = bonus
0.1X + X = 150,000.00
Then 1.1X = 150,000.00
X = 150,000.00 / 1.10
X = 136,363.64
0.1X = 13,636.36
Schedule of Profit Distribution
Mark Felipe Total
Salary allowances 25,000.00 30,000.00 55,000.00
Interest allowances 7,200.00 5,600.00 12,800.00
Bonus to Felipe 13,636.36 13,636.36
Remainder, equally 34,281.82 34,281.82 68,563.64 (squeezed amount)
Totals 66,481.82 83,518.18 150,000.00

Case 3. Net income after allowances for salaries, interest but before bonus
Under this method, the interest and salary allowances are treated as expense.

Net income before salaries, interest and bonus 150,000.00

Less: Salaries 55,000.00
Interest 12,800.00 67,800.00
Net income before bonus 82,200.00
Bonus percentage 10%
Bonus 8,220.00

Schedule of Profit Distribution

Mark Felipe Total
Salary allowances 25,000.00 30,000.00 55,000.00
Interest allowances 7,200.00 5,600.00 12,800.00
Bonus to Felipe 8,220.00 8,220.00
Remainder, equally 36,990.00 36,990.00 73,980.00 (squeezed amount)
Totals 69,190.00 80,810.00 150,000.00

Case 4. Net income after allowances for salaries, interest and bonus
Under this method, the interest, salary and bonus allowances are treated as expense.

Let X = bonus
X = 10%(P150,000.00-55,000.00-12,800.00-X)
X = P15,000.00-5,500.00-1,280.00-0.10X
1.1X = 8,220.00
X = 7,472.73
Schedule of Profit Distribution
Mark Felipe Total
Salary allowances 25,000.00 30,000.00 55,000.00
Interest allowances 7,200.00 5,600.00 12,800.00
Bonus to Felipe - 7,472.73 7,472.73
Remainder, equally 37,363.64 37,363.64 74,727.27 (squeezed amount)
Totals 69,563.64 80,436.37 150,000.00

CHANGES IN THE PROFIT AND LOSS RATIO

Anytime, partners may agree to change their profit and loss ratio, however, accounting
problems may arise and that some adjustments must be made to reflect the actual fair value
of each partners' interests under two different approaches:

1. Adjustment of all assets and liabilities to its fair values and record any unrecorded assets or liabilities, if any.
All these effects shall be reflected in the partners' account balances and divided based on their old profit/loss ratio.
2. Adjust only the partner's capital account for the net effect of all differences between the book values and
fair values of assets and liabilities and shared still, using their old profit or loss ratio.

Illustration: For instance, Mark and Felipe, who currently shares profits and losses equally decided to
change their ratio to 60% to Mark and 40% to Felipe. Assume that on the date of change, the partnership's
owned building that was carried at cost of P350,000.00 has now a fair value of P700,000.00. Months later,
the building was sold at P1,500,000.00

First Approach: The change in the value of the building shall be reflected both in asset and partners' equity accounts.
Entry to record the effect:
Building 350,000.00
Mark, capital 175,000.00
Felipe, capital 175,000.00

Entry to record the effect of gain on sale of building

Cash 1,500,000.00
Building 700,000.00
Mark, capital 480,000.00
Felipe, capital 320,000.00
Second Approach: The change in the value of the building shall be reflected only in each partners' capital accounts.
Entry to record the effect:
Felipe, capital 35,000.00
Mark, capital 35,000.00
To credit Mark capital with 10% (50%-40%) of P350,000.00 for his share of increase in value of the Building
and to charge Felipe's capital account accordingly.

Mark Felipe Total

Portion of gain developed prior to change in ratio
(P700,000.00-350,000.00), Divided equally 175,000.00 175,000.00 350,000.00

Portion of gain developed on sale of building

(P1,500,000.00-700,000.00), Divided 60:40 480,000.00 320,000.00 800,000.00

Totals 655,000.00 495,000.00 1,150,000.00

Entry to record the effect of gain on sale of building
Cash 1,500,000.00
Building 350,000.00
Mark, capital 655,000.00
Felipe, capital 495,000.00

CORRECTION OF PARTNERSHIP INCOME OF PRIOR PERIOD

The partnership may discover errors from prior year so the net income must be corrected, compute the proper
share of each partners using the profit and loss ratio in the year in which the error occurred, compute the difference
between the actual profit share received and the share each partner would have received ans adjust the capital
account balances of each partner.

Illustration: Assume that in 2020, the reported net income of Mark and Felipe was P180,000.00 and that partners
divide the profits and losses equally. During 2021, the following errors were discovered:
1. Depreciation was overstated by P15,000.00
2. Deferred revenues was overstated by P10,000.00
3. Prepaid expenses was overstated by P25,000.00
4. Accrued expenses of P35,000.00 was omitted.

Adjustment to 2020 Net income:

Net Income per books, 2020 P180,000.00
Adjustments:
Overstatement of depreciation 15000
Overstatement of Deferred revenues 10000
Overstatement of Prepaid expenses -25000
Omission of Accrued expenses -35000 -35000
Corrected net income 145,000.00

Required adjustment to partners' capital account balances:

Mark Felipe Total
2020 Net income before corrections 90,000.00 90,000.00 180,000.00
2020 Corrected Net income 72,500.00 72,500.00 145,000.00
Required reduction to capital accounts 17,500.00 17,500.00 35,000.00

Entry to record adjustment to partners' capital accounts

Debit Credit
Mark, Capital 17,500.00
Felipe, Capital 17,500.00
Deferred Revenue 10,000.00
Accumulated Depreciation 15,000.00
Accrued expense 35,000.00
Prepaid Expenses 25,000.00

Adjusting Journal Entries:

Accumulated Depreciation 15,000.00
Mark, Capital 7,500.00
Felipe, Capital 7,500.00
Deferred Revenues 10,000.00
Mark, Capital 5,000.00
Felipe, Capital 5,000.00
Mark, Capital 12,500.00
Felipe, Capital 12,500.00
Prepaid Expenses 25,000.00
Mark, Capital 17,500.00
Felipe, Capital 17,500.00
Accrued Expenses 35,000.00