LESSON 3 PARTNERSHIP OPERATIONS (3

HOURS)
Nature of Partnership Operations

A business partnership operates like any other forms of profit-oriented

business It manufactures, sells products or provides services for a profit.

The accounting process of a partnership's transactions is basically similar to

the accounting process for sole proprietorships or corporations. Their
differences, however, lie in the plurality of presenting partners' capital in the
statement of financial position and in the distribution of partnership earnings
to the partner.

In sole proprietorship, there is no sharing of profit or loss because there is only

one owner who taken the benefit or burden of the business. In partnership
business, however, the distribution of profits or loss usually depends on the
partners agreement and on the number of partners.

In corporation, profits are distributed in the form of dividends based on the

declaration by the board of directors from the undistributed retained earnings
of the business.

COMPARATIVE PROFIT DISTRIBUTION

Single Proprietorship Partnership Corporation
The profits or losses are all The profits and losses are Profits are distributed in the
taken by the only owner, the divided based on partners’ forms of dividends based on
sole proprietor. agreement. the decision by the board of
directors.

Accounting for Partnership Operation

The accounting for partnership operation is primarily concerned with the

following activities:

1. Accounting treatment of profit and loss;

2. Proper distribution of profit and loss; and

3. Preparation of financial statements such as:

a. Statement of Comprehensive Income (Income Statement)

b. Statement of Financial Position (formerly Balance Sheet)

c. Partners’ capital statement (Statement of Changes in Pattern Equity)

Accounting Treatment of Partnership Profit and Loss

The determination of proper income or loss is made through the preparation

of income statement with the following basic:

Revenues ₱xxxx
Less: Operating Expenses xxxx
Net Income (Loss) ₱xxxx
In the journal entry, there is net income if the income summary account has a
credit balance. There is net loss if the income summary account has debit
balance.

The profit or loss is subsequently distributed to the partners by closing the

income summary account to the respective partners' capital accounts.

ILLUSTRATION 1

Assume that Eye & Bee Partnership has credit balance of income summary
account amounting to P500,000. If partners Eye and Bee divide profit equally,
the journal entry to distribute the net income would be:

GENERAL JOURNAL

(Eye & Bee Partnership)

Date Descriptions Debit Credit
6/30Income Summary ₱250,000
Eye, Capital ₱125,000
Bee, Capital 125,000
To record profit distribution, equally.

ILLUSTRATION 2

Assume that Eye and Bee Partnership has a credit balance of income summary
account amounting to ₱250,000. If partners Eye and Bee divide losses with 60%
and 40% loss sharing respectively, the journal entry to distribute the net loss
would be:

GENERAL JOURNAL

(Eye & Bee Partnership)

Date Descriptions Debit Credit
 6/30Income Summary ₱250,000
Eye, Capital (₱250,000 x 60%) ₱125,000
Bee, Capital (₱250,000 x 40%) 125,000
To record profit distribution to Eye and Bee, 60%
and 40%, respectively.

TEACHER’S INSIGHTS:

The net income or loss can also be closed first to the partners drawing accounts and
then the partners drawing accounts and then the partners’ drawing accounts are
subsequently closed to the partners’ capital accounts. To simplify the entries, the net
income or loss is directly closed to the partners’ capital accounts.

Sharing Partnership Profits and Losses

The primary objective of the accounting for partnership operations in

the determination of periodic net income and its distribution to the partners.

Accountants usually observe the accrual method of accounting and generally

accepted accounting principles (GAAP) because GAAP results in a better
measure of determining income.

The determination of net income is calculated in traditional manner- that is, by

relating the partnership's periodic revenues and expenses.

In measuring partnership income for the period, however, the expenses should
be scrutinized to make sure that personal expenses of the partners are not
suited among the partnership's business expenses.

If personal expenses of a partner are paid with partnership assets, the payment
is charged to the drawing or capital account of the partner whose personal
obligations have been settled.

This is because the partnership business treated as a separate and distinct

person from the partners in accordance with the accounting entity concept.

The Laws on Partnership Profits and Losses Distribution

Article 1799 of the New Civil Code provides that any stipulation that exclude
one or more partners from any share in the profits or losses is void. The reason
for this is that partnership must coast for the common benefit and interest of
the partners.
Article 1797 of the New Civil Code of the Philippines provides the following
guidelines on how partnership profits and losses shall be distributed among
the partners:

Rules on Profits Sharing

Profit Sharing Based on Partners' Agreement. Profits of the partnership shall be

divided among the partner in accordance with their profit-sharing Tato
agreement.

ILLUSTRATION

Moses and Joshua have capital balances of ₱550,000 and ₱450,000

respectively. The partnership earned a net income of ₱300,000. Their profit
agreement is 60% and 40%, respectively.

The profit distribution between Moses and Joshua would be ₱300,000:

Profit of ₱300,000: Moses (60%) Joshua (40%) Total

Share of Moses (₱300,000 x 60%) ₱180,000 ₱180,000
Share of Joshua (₱300,000 x 40%) . ₱120,000 ₱120,000
Total ₱180,000 ₱120,000 ₱300,000

TEACHER’S INSIGHT:

The capital contribution of the partners has no bearing in the profit distribution base
their profit rating agreement should be followed.

Profit Sharing Based on Capital Contribution. In the absence of a

profit-sharing agreement, profits shall be divided among the partners in
proportion to the respective capital contributions.

ILLUSTRATION

Using the same data in the preceding illustration, the profit distribution
between Moses and Joshua if they have no profit and loan agreement would
be:

Profit of ₱300,000: Moses (55%) Joshua (45%) Total

Share of Moses (₱300,000 x 55%) ₱165,000 ₱165,000
Share of Joshua (₱300,000 x 45%) . ₱135,000 ₱135,000
Total ₱180,000 ₱120,000 ₱300,000
 TEACHER’S INSIGHTS:

1. Since there is no P&L ratio agreement between Moses and Jonas, their capital
contributions are considered as the basis of profit or loss distribution.

2. The fraction or percentage follows derived from their capital ratio, computed as
follows:

Fraction Percentage
Moses (₱550,000/ ₱1,000,000) 55/100 55%
Joshua (₱450,000/ ₱1,000,000) 45/100 45%

Profit Sharing Based on Capital Contribution and on Service. The following

rules are observed when the profit distribution is based on capital contribution
and on services rendered by a partner:

Rule 1: If there is an industrial partner. he first gets a just and equitable share
for his services (industry), before the capitalist partners divide the balance of
the profits in proportion to their capital contributions.

ILLUSTRATION

Let us use the same illustration above, this time involving a third person whom
we shall call Caleb, as industrial partner in the partnership. It was agreed that
Caleb, being an industrial partner, will receive a profit share equivalent to 10%
of the partnership net income. The distribution of ₱300,000 profit would be:

Profit of ₱300,000: Moses (55%) Joshua Caleb Total

(45%)
(Industrial)
Share of Caleb ((₱300,000 x 10%) ₱30,000 ₱30,000
Share of Moses (₱300,000 - 30,000) x 55% ₱148,500 ₱180,000
Share of Joshua (₱300,000 - 30,000) x 45% . ₱121,500 . ₱120,000
Total ₱180,000 ₱120,000 ₱30,000 ₱300,000

Rule 2: If there is no specified profit sharing for an industrial partner, he shall

receive a share equal to the share of a capitalist partner having the smallest
share.

Again, take the illustration above, minus the profit agreement among the
capitalist partners and industrial partner. In this case, the distribution of the
partnership net profit would be:
Profit of ₱300,000: Moses (55%) Joshua (45%) Caleb Total

(Industrial)
Share of Caleb (₱300,000 x 45/ 145) ₱93,103 ₱93,103
Share of Moses (₱300,000 x 55/ 145) ₱113,794 ₱113,794
Share of Joshua (₱300,000 x 45/ 145) . ₱93,103 . ₱93,103
Total ₱180,000 ₱120,000 ₱30,000 ₱300,000

TEACHER’S INSIGHTS:

1. The capital contribution of Joshua shall be used to allocate the share of Caleb from the profit of
the partnership because there was no profit share agreement for the industrial partner.

2. The fraction is derived by simply adding 45 profit shares of the industrial partner to the profit
sharing of Moses and Joshua based on their contributed capital as 55 and 45 respectively, or total
units of profit to be shared on 145 computed as follow:

Fraction Percentage
Moses, per capital contribution = 55 55/145 37.94%
Joshua, per capital contribution = 45 45/145 31.03%
Caleb = the smallest share of capitalist partner or 45 45/145 31.03%
Total (55 + 45 + 45) = 145 145/145 100%

Rule 3: If there is a Capitalist/Industrial Partner, he gets just and equitable

share as an industrial partner and another share as a capitalist partner
according to his capital contribution.

ILLUSTRATION

Assume that Caleb contributed a capital of ₱250,000 and, per partnership

agreement, he would receive a profit share of 10% from the profit of the
partnership as an industrial partner. There is no sharing agreement between
the pure capitalist partner.

Profit of ₱300,000: Moses (55%) Joshua (45%) Caleb Total

(Industrial)
Share of Caleb
As industrial (₱300,000 x 10%) ₱30,000 ₱30,000
As capitalist (₱300,000 x 18%) 54,000 54,000
Share of Moses (₱300,000 x 39.60%) ₱118,800 118,000
Share of Joshua (₱300,000 x 32.40% . ₱97,200 . 97,200
Total ₱180,000 ₱120,000 ₱30,000 ₱300,000
 TEACHER’S INSIGHTS:

1. The new profit and loss sharing ratio is computed as follows:

Partner’s Capital Computations New Profit Ratio

Caleb as industrial (100%-90%) 10.00%
Caleb as capitalist ₱ 250,000 90% x 25/125 18.00%
Moses 550,000 90% x 55/125 39.60%
Joshua 450,000 90% x 45/125 32.40%
1,250,000 100.00%
2. Even if Caleb has already received his share as an industrial partner, he entitled to
receive to additional share from the remaining balance of the partnership profit
because be in a capitalist partner at the same time.

Rules on Losses Sharing

Loss Sharing Based on Partners’ Agreement. The following rules are

observed when the loss distribution is based on partners’ agreement.

Rule 1: Loss of the partnership shall be divided among the partners in

accordance with their profit or loss sharing agreement.

ILLUSTRATION

Moses and Joshua have capital balance of ₱65,000 and ₱35,000, respectively.
The partnership suffered a net loss of ₱30,000, They agree that any profit shall
be divided 60% and 40% respectively, but losses shall be divided equally.

The distribution of loss would be:

Loss of ₱30,000 Moses (50%) Joshua (50%) Total

Share of Moses (₱30,000 x 50%) (₱15,000) (₱15,000)
Share of Joshua (₱30,000 x 50%) . (₱15,000) (₱15,000)
Total (₱15,000) (₱15,000) (₱30,000)

TEACHER’S INSIGHTS:

1. The profit-sharing ratio is different from the loss sharing ratio, so the latter shall be
used because there is a loss from operation.

2. The capital contributions of the partners have no bearing in the profit distribution
because their profit and loss ratio agreement should be followed.
 Rule 2: In the absence of loan sharing agreement, loan shall be apportioned
among the partners in accordance with their profit-sharing ratio.

ILLUSTRATION

Using the same information above except that there was no loss ratio
agreement, the distribution of partnership net loss would be:

Loss of ₱30,000 Moses (60%) Joshua (40%) Total

Share of Moses (₱30,000 x 60%) (₱18,000) (₱18,000)
Share of Joshua (₱30,000 x 40%) . (₱12,000) (₱12,000)
Total (₱18,000) (₱12,000) (₱30,000)

The existing 60% and 40% profit ratio of Moses and Joshua, respectively, was
applied.

Loss Sharing Based on Capital Contribution. In the absence of any loss

sharing and profit-sharing ratios, loss shall be divided among the capitalist
partners in accordance with their capital contributions.

ILLUSTRATION

Using the same illustration above except that there was no profit or loss
sharing agreement among the partners, the distribution of the ₱300,000
partnership loss would be:

Loss of ₱300,000 Moses (55%) Joshua (45%) Total

Share of Moses (₱300,000 x 55%) (₱180,000) (₱180,000)
Share of Joshua (₱300,000 x 45%) . (₱120,000) (₱120,000)
Total (₱180,000) (₱120,000) (₱300,000)

TEACHER’S INSIGHT:

The fraction or percentage is derived from their capital ratio, computed as follows:

Fraction Percentage
Moses (₱550,000/ ₱1,000,000) 55/100 55%
Joshua (₱450,000/ ₱1,000,000) 45/100 45%
100/100 100%

Loss Sharing of an Industrial Partner. The following rules are applicable for
loss distribution to an industrial partner:
 Rule 1: If there is no agreed loan or profit-sharing ratio and there is a "pure”
industrial partner, he is totally exempt from sharing in the loss.

ILLUSTRATION

Assume the same data as stated above, this time with a “pure" industrial
partner named Caleb If the partnership suffered a net loss of ₱300,000, the
distribution of the loss would be:

Loss of ₱300,000: Moses Joshua Caleb Total

(55%) (45%)
(Indrustrial)
Share of Caleb ₱ -0- ₱ -0-
Share of Moses (₱300,000 x (₱180,000) (₱180,000)
Share of Joshua (₱300,000 x . (₱120,000) . (₱120,000)
Total (₱180,000) (₱120,000) ₱ - 0 - (₱300,000)

TEACHER’S INSIGHT:

1. Industrial partner does not share in partnership losses because he already rendered
in space his service in vain.

2. If there is profit and loss ratio agreement in which the industrial partner in included
the profit and loss sharing ratio, he is bound to respect the contract between them by
his co-partners He shall therefore share in the loss equivalent to his agreed loss ratio
even he is an industrial partner

3. However, there profit sharing ratio and there is no loss ratio, the industrial partner
in not bound to share in the partnership losses because he did not give his consent to
have his share in the partnership loss.

Rule 2: However, it must be carefully noted that with respect to an Industrial

capitalist partner if there is no loan sharing agreement but there I profit
sharing agreement in which the industrial-capitalist partner in entitled to a
profit ratio, be then becomes liable for the loss of the partnership in the same
proportion as his profit sharing ratio.

ILLUSTRATION

Assume that Caleb contributed a capital of ₱250,000 and per partnership

agreement, he would receive 10% of partnership profit as an industrial partner.
The partnership agreement also stipulates that the capitalist partner will share
equally in the partnership's profit and loss. The distribution of ₱300,000 net
loan would be:
Loss of ₱300,000: Moses (1/3) Joshua (1/3) Caleb (1/3) Total
Share of Caleb (₱300,000 x 1/3) (₱100,000) (₱100,000)
Share of Moses (₱300,000 x 1/3) (₱100,000) (100,000)
Share of Joshua (₱300,000 x 1/3) . (₱100,000) . (100,000)
Total (₱100,000) (₱100,000) (₱100,000) (₱300,000)

TEACHER’S INSIGHTS

1. The industrial partner is not exempted from the loss sharing once he becomes a
capitalist partner.

2. If there are partnership loss however, the industrial partner shall not absorb share
from the net losses. He shall share only in the loss as a capitalist partner.

Arbitrary Agreements in Computing Profits and Losses

Partners may share the partnership profits and losses in any manner they wish.
The profit and loss agreement should contain specific and complete provisions
to avoid misunderstanding and disputes among the partners.

The agreement on partnership profits and losses may be divided into one of
the following ways:

1. Equally

2. Specified ratio or percentage

3 Capital ratios

4. Interest allowed on partner's capitals, the remainder to be divided in an

agreed ratio

5. Salaries or bonus allowed for partner' services, the remainder to be divided

in an agreed ratio

6. Multiple bases of allocation

To illustrate the methods that could be agreed upon for profit and loss
distribution, assume that Ralph and Vince formed a partnership with original
capital contributions of ₱180,000 and ₱90,000, respectively.
In the second year of the partnership operations, the capital and drawing
balances of partners Ralph and Vince traced from the general ledger as
follows:

Ralph, Drawing
Debit Credit
5/30 30,000 .
30,000

Vince, Drawing
Debit Credit
5/30 15,000 .
15,000

Ralph, Capital
Debit Credit
8/30 180,000 180,0001/1
120,0006/30
. 330,0009/30
180,000 630,000
450,000

Vince, Capital
Debit Credit
5/1 180,000 150,0001/1
90,0002/30
. 240,00010/1
180,000 480,000
300,000

During the year, the partnership generated an income of ₱600,000.

Note: Unless otherwise stated, the data above shall be used as the basis for
illustrations in the succeeding discussions.

Equally

The partners may mutually agree that the partnership profit shall be equally
divided between them. In case of losses and in the absence of specified
agreement regarding division of losses, the existing equal division of profit
agreement is to be followed by the partners.
Adam and Eve agreed to divide the partnership profit equally the distribution
of ₱600,000 profit would be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Equally (50%) (50%) (100%)
Computation:
Ralph (₱600,000 x 50%) ₱300,000 ₱300,000
Vince (₱600,000 x 50%) . ₱300,000 300,000
Net Income Distribution ₱300,000 ₱300,000 ₱600,000

It is to be observed that Ralph and Vince shared on the partnership profits

equally regardless of the unequal balances of their capital contributions. To
record the distribution of profit, the following journal entries shall be made:

GENERAL JOURNAL

(Ralph Vince Partnership)

Date Descriptions Debit Credit
6/30Income Summary ₱600,000
Ralph, Drawings ₱300,000
Vince, Drawings 300,000
To record profit distribution, equally.

The profit and loss distribution can also immediately be closed to the partners’
capital accounts because the partners' drawing accounts are ultimately closed
to the capital accounts.

An alternative journal entry capital is to distribute net income directly to the

partners’ capital accounts, as follows:

GENERAL JOURNAL

(Ralph Vince Partnership)

Date Descriptions Debit Credit
6/30Income Summary ₱600,000
Ralph, Capital ₱300,000
Vince, Capital 300,000
To record profit distribution, equally.
For the succeeding illustrations, the drawing accounts will be used closing the
profit or loss account.

Specified Ratio or Percentage

Whenever the presence of one of the partners in perceived more vital to the
success of the business due to experience, ability and reputation, the profit and
loss agreement may stipulate an unequal sharing expressed in agreed or
percentage, otherwise called as arbitrary ratio.

In specific ratio, the difference in the partner's capital balance has no bearing
in the profit and share the agreed profit and loss ratio may be based on the
partners better capability or influence over the other.

To illustrate assume that Vince is perceived more vital than Ralph for the
success of the partnership business, so much so that they agreed to share in
the profit and loss of 60% and 40%, respectively.

Based on the profit and loss agreement, Adam and Eve shall apportion the
₱600,000 profit in the following manner:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Equally (50%) (50%) (100%)
Computation:
Ralph (₱600,000 x 40%) ₱240,000 ₱240,000
Vince (₱600,000 x 60%) . ₱360,000 360,000
Net Income Distribution ₱240,000 ₱360,000 ₱600,000

In spite of Ralph’s greater ending capital balance (₱450,000) than that of Vince
(₱300,000), the latter received a greater share from the partnership profit
because the specified percentage on profit and loss agreement provides her
60% share from the partnership earnings.

The journal entry to affect the profit distribution in the books of accounts
would be:

GENERAL JOURNAL

(Ralph Vince Partnership)

Date Descriptions Debit Credit
 6/30Income Summary ₱600,000
Ralph, Drawings ₱240,000
Vince, Drawings 360,000
To record profit distribution with 40% and 60%
sharing.

Relative Capital Balances

When money or properties invested by the partners represent the vital

contribution to the success of the partnership business, partners may agree
that their respective capital balances shall be the basis of the profit and loss
sharing.

This manner of dividing profit and loss is different from a situation where there
is no profit and loss agreement at all or where an arbitrary specified ratio or
percentage is used for profit sharing. This is for the allocation of profit and loss
distribution in not fixed due to fluctuation of the capital balances of the
partners.

The accounting issue in the capital ratio lies on what amount of the partners’
capital shall be considered in the computation of profit distribution. For this
reason, the agreement should indicate specifically whether the ratio is to be
defined in terms of:

1. Original capital contribution;

2. Beginning capital balance of the accounting year;

3. Ending capital balance of the accounting year; and

4. Average capital balance of the year.

Original Capital Contributions. If the partners agreed that the periodic

division of profits and losses be based upon their respective original capital
contributions the reference should be made to the amount originally invested
by the partners.

To distribute the ₱600,000 net income of the partnership to Ralph and Vince,
the following computation should be made:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

 Ralph Vince Total
Original Capital Investment ₱180,000 ₱90,000 ₱270,000
Computation:
Ralph (₱600,000 x 18/27) 400,000 400,000
Vince (₱600,000 x 9/27) . 200,000 200,000
Net Income Distribution ₱400,000 ₱200,000 ₱600,000

TEACHER’S INSIGHTS

The fraction is computed by dividing the original capital investment by the total
original capital investments, as follows:

Partner Amounts Fraction

Ralph ₱180,000 18/27
Vince ₱90,000 9/27
Total ₱270,000 27/27

To record the profit distribution, the journal entries would be:

AL JOURNAL

(Ralph Vince Partnership)

Date Descriptions Debit Credit
6/30Income Summary ₱600,000
Ralph, Drawings ₱400,000
Vince, Drawings 200,000
To record profit distribution with 40% and 60%
sharing.

Beginning Capital Balance of the Accounting Year. If the partner agreement

provides that the periodic division of profits and losses shall be based upon
the capital balances at the beginning of the year then the opening pattern
capital balance of the current year shall be the basis of the profit and loss
allocation.

To distribute the ₱600,000 net income of the partnership to Ralph and Vince,
the following computation should be made:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Beginning Capital Balances ₱180,000 ₱150,000 ₱330,000
Computation:
Ralph (₱600,000 x 18/33) 218,182 218,182
Vince (₱600,000 x 15/33) . 181,818 181,818
Net Income Distribution ₱218,182 ₱181,818 ₱600,000

TEACHER’S INSIGHTS

The disadvantage of beginning capital balance method is that it discourages additional

investments during the accounting period because such investments are no
compensated in the division of profit until the next year's period.

The journal entry in the distribution the profit would be:

GENERAL JOURNAL

(Ralph Vince Partnership)

Date Descriptions Debit Credit
6/30Income Summary ₱600,000
Ralph, Drawings ₱218,182
Vince, Drawings 181,818
To record profit distribution based on the
partners’ beginning capitals.

Ending Capital Balances of the Accounting Year. Of the partners agreed

that the division of profits and losses shall be based upon the partners’ capital
balances at the end of each year all transactions affecting the capital accounts
shall be then considered and the ending capital balance shall be the basis of
the profit and loss allocation.

The ending capital accounts of each partner are determined by getting the
account balances of the partners' capital accounts, as follows:

Ralph, Capital
Debit Credit
8/30 180,000 1/1 180,000
6/30 120,000
. 9/30 330,000
180,000 630,000
450,000
 Vince, Capital
Debit Credit
5/1 180,000 1/1 150,000
2/30 90,000
.10/1 240,000
180,000 480,000
300,000

The profit distribution schedule of Adam and Eve would be

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Beginning Capital Balances ₱450,000 ₱300,000 ₱750,000
Computation:
Ralph (₱600,000 x 45/75) 360,000 360,000
Vince (₱600,000 x 30/75) . 240,000 240,000
Net Income Distribution ₱360,000 ₱240,000 ₱600,000

TEACHER’S INSIGHTS

1. Drawing accounts are not included in the computation of the ending capital
balances because they only reflect temporary reduction of the capital balances
representing advances to partners in anticipation of partnership profit

2. The disadvantage of using the year end capital balance method is that there i no
incentive for a partner to make any investments in the earlier parts of the year.

To record the profit distribution, the journal entry would be:

GENERAL JOURNAL

(Ralph Vince Partnership)

Date Descriptions Debit Credit
6/30Income Summary ₱600,000
Ralph, Drawings ₱360,000
Vince, Drawings 240,000
To record profit distribution based on the
partners’ beginning capitals.

Average Capital Balances of the Accounting Year. When partners agreed to

divide profit to recognize capital changes during the current period, the use of
the partners average capital balances shall be employed Thin method to
encourages partners to contribute during the year additional investments to
the partnership.

An accounting issue is used to whether or not drawings made by partners

during the financial period shall be included in the computation of average
capital. As a rule, drawing accounts are not considered in the computation of
ending capital except when stated otherwise.

Methods of Computing Average Capitals

There are methods of computing the average capitals of the partners may be
done by using the following methods:

1. Simple Average Capital Method. This method in computed by simply

dividing the sum of the beginning and ending capital by 2. The simple average
capital balances are computed as follows:

Partners: Computations Simple Average Fraction

Ralph (180,000+450,000)/ 2 ₱315,000 315/540
Vince (150,000+300,000)/ 2 225,000 225/540
Totals ₱540,000 540/540

Using the simple average capital method, the distribution of ₱600,000 profit
would be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Simple Average Capitals ₱315,000 ₱225,000 ₱750,000
Computation:
Ralph (₱600,000 x 315/540) 360,000 360,000
Vince (₱600,000 x 225/540) . 240,000 240,000
Net Income Distribution ₱360,000 ₱240,000 ₱600,000

Weighted Average Capital Method. This method is also known as

"peso-month or "peso-day” average capital method. Under this method, the
computation of the verge capital considers the period in which the capital
contributions have been used in a given accounting period.

The weighted average capital based on peso months is computed as follows:

 PARTNERSMONTHS NUMBER OF COMPUTATIONS PESO-MONTHS Fraction
MONTHS USED AVERAGE

Ralph 1/1 12 ₱180,000 x 12/12 ₱180,000

6/30 6 120,000 x 612 60,000
8/30 (4) 180,000 x 4/12 (60,000)
9/30 3 330,000 x 3/12 82,500
₱262,500 2,625/4,200

Vince 1/1 12 ₱150,000 x 12/12 ₱150,000

3/30 9 90,000 x 9/12 67,500
5/1 (8) (120,000 x 8/12) (120,000)
10/1 3 240,000 x 3/12 60,000
₱157,500 1,575/4,200

Using this method, the ₱600,000 partnership income shall be distributed as follows:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Peso-Month Average Capitals ₱262,500 ₱157,500 ₱4,200,000
Computation:
Ralph (₱600,000 x 2,625/4,200) 375,000 375,000
Vince (₱600,000 x 1,575/4,200) . 225,000 225,000
Net Income Distribution ₱375,000 ₱225,000 ₱600,000

TEACHER’S INSIGHTS

1. The weighted average capital method should be assumed in the absence of evidence
to the contrary. Average capital means weighted average unless another interpretation
of average capital is specified in the agreement.

2. The average capital method is the best alternative compared to beginning and
ending capital methods because it provides the most equitable basis for allocating
partnership income.
Allowance of Interest on Partners' Capital

This agreement provides that the cost of money on the capital contributions of
partners will be added as a profit-sharing device in addition to the profit and
loss ratio agreement.

It is based on the philosophy that if the capital contributions have been

invested in other earning activities such as trading securities, the partner
should have realized additional revenue.

The allowance of interest may be computed on the following bases;

1. Interest on capital balances, and

2. Interest on excess investments.

Interest on Capital Balances. This method allocates first portion of profit

equivalent to certain interest rate of the partners’ capital balance. Accordingly,
the capital balance should clearly be defined in the agreement. The remaining
balance of the profit shall be distributed in accordance with the agreed
arbitrary ratio.

In the absence of the agreed arbitrary ratio, the partners' original capital
contribution may be used to allocate the undistributed balance of profit

ILLUSTRATION

Assume that Ralph and Vince agreed that their respective average capital
balances are entitled to a 12% interest per year and the balance will be
distributed 60% and 40%, respectively. The average capital balances of Ralph
and Vince are ₱262,500 and ₱157,500, respectively. The distribution of
₱600,000 profit would be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Ratio on the remaining balance 60% 40% 100%
12% interest on the average capital
Ralph (₱262,500 x 12%) ₱31,500
Vince (₱157,500 x 12%) ₱18,900 ₱50,400
Distribution of Balance/Remainder:
Ralph (₱600,000 - 50,400) x 60% 329,760
Vince (₱600,000 - 50,400) x 40% . 219,840 549,600
Net Income Distribution ₱361,260 ₱238,740 ₱600,000

Interest on Excess Investments. This method allows interest on the excess

capital balance of one partner over that of another.

ILLUSTRATION

Assume that Ralph and Vince agreed that the excess of one partner's average
capital balance is entitled to a 12% interest per year and the balance
partnership profit will be distributed 60% and 40%, respectively.

The average capital balances of Ralph and Vince are ₱262,500 and ₱157,500,
respectively. The distribution of ₱600,000 profit would be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Ratio on the remaining balance 60% 40% 100%
Interest on excess of Ralph’s capital
over Vince
(₱262,500 - ₱157,500) x 12% ₱12,600 ₱12,600
Distribution of Balance/Remainder:
Ralph (₱600,000 - 12,600) x 60% 352,440
Vince (₱600,000 - 12,600) x 40% . 234,960 587,960
Net Income Distribution ₱365,040 ₱234,960 ₱600,000

TEACHER’S INSIGHT

Ø The agreement for interest may still employ other forms. For instance, a fixed
capital contribution is agreed for each partner with interest allowed on amount in
excess of such fixed amounts and interest charged on any deficiencies.

Salaries or Bonus Allowed for Partners Services

An equitable division of profits and losses frequently requires that financial

consideration be given to the skills, talents, efforts and work hours that active
partners devote to the partnership business in addition to their capital
investment. Consequently, salaries and/or bonuses may be given to a partner
before the agreed profit-sharing ratio distribution is made.
Salaries. To recognize personal contribution by the partner to the business,
they may agree to receive salary, and divide the remaining profit among
themselves by the agreed specified ratio. Except when stated otherwise, salary
allowances are part of the net income/loss allocation to the partners.

ILLUSTRATION

Assume that the Ralph and Vince Partnership's operation was a 12-month
period and that they agreed that a salary of ₱6,000 per month be given to each
of the partner for their personal services in addition to a 12% interest on their
average capital balances. The balance partnership profit will be distributed
60% and 40%, respectively. The average capital balances of Ralph and Vince
are ₱262,500 and ₱157,500, respectively. The distribution of ₱600,000 profit
would be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Ratio on the remaining balance 60% 40% 100%
Salary of each partner (₱18,000 x 12) ₱216,000 ₱216,000 ₱432,000
12% interest on the average capital
Ralph (₱262,500 x 12%) ₱31,500
Vince (₱157,500 x 12%) ₱18,900 ₱50,400
Distribution of Balance/Remainder:
Ralph (₱600,000 - 432,000-50,400) x 70,560
60%
Vince (₱600,000 - 432,000-50,400) x . 47,040 117,600
40%
Net Income Distribution ₱365,040 ₱234,960 ₱600,000

TEACHER’S INSIGHT

Ø Salaries will be always given regardless if the partnership’s operation resulted to

loss, except when partnership agreement state otherwise.

Bonus. A partnership agreement may provide that a managing partner be

allowed bonus on the earnings of the business to encourage profit
maximization.

The bonus may be computed as follows:

Bonus = Bonus rate x Base net income*

 *The base net income is always assumed to be 100%.
The bonus agreement is basically stated as a percentage of net income. The
bonus may be based on the following net income:

1. Net income before deducting salaries, interest (if any) and bonus;
2. Net income after deducting salaries and interest (if any) but before bonus; or
3. Net income after deducting salaries, interest (if any) and bonus.

Multiple Bases and Priority of Allocation

This procedure depends on the partners agreement regarding the order of

priority in allocating the multiple basis of profit or loss.

To divide profit equitably, partners may agree that their salaries be first given
priority over interest on capital and bonus, and if there is a remainder, it shall
be divided in an agreed ratio.

Case 1: Bonus is based on net income before deducting salaries, interest any (if
any), and bonus (is treated as part of profit distribution).

Assume that Ralph and Vince agreed to the following:

a. Each of them would have a salary of ₱15,000 per month one-year operation;
b. 12% interest on their respective average capital;
c. 10% bonus of net income before salaries, before interest on capital and before the
bonus to Ralph, the managing partner; and
d. The balance of net income shall be divided on the basis of 60% and 40%,
respectively.

The average capital balances of Ralph and Vince are ₱262,500 and ₱157,500,
respectively. The distribution of ₱600,000 profit would be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Ratio on the remaining balance 60% 40% 100%
Salary of each partner (₱15,000 x 12) ₱180,000 ₱180,000 ₱360,000
12% interest on the average capital
Ralph (₱262,500 x 12%) 31,500
Vince (₱157,500 x 12%) 18,900 50,400
Bonus to Ralph (₱600,000 x 10%) 60,000 60,000
Distribution of Balance/Remainder:
Ralph (₱600,000-360,000-50,400-60,000) 77,760
x 60%
Vince (₱600,000-360,000-50,400-60,000) . 51,840 129,600
x 40%
Net Income Distribution ₱349,260 ₱250,740 ₱600,000

Case 2. Bonus is based on net income after deducting salaries and interest (if
any) but before bonus.

Assume that Ralph and Vince agreed to the following:

a. Each of them would have a salary of ₱15,000 per month one-year operation;
b. 12% interest on their respective average capital;
c. 10% bonus of net income after salaries and interest on capital and before the bonus
to Ralph, the managing partner; and
d. The balance of net income shall be divided on the basis of 60% and 40%,
respectively.

The average capital balances of Ralph and Vince are ₱262,500 and ₱157,500,
respectively. The distribution of ₱600,000 profit would be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Ratio on the remaining balance 60% 40% 100%
Salary of each partner (₱15,000 x 12) ₱180,000 ₱180,000 ₱360,000
12% interest on the average capital
Ralph (₱262,500 x 12%) 31,500
Vince (₱157,500 x 12%) 18,900 50,400
Bonus to Ralph (₱189,600 x 10%) 18,960 18,960
Distribution of Balance/Remainder:
Ralph (₱170,649 x 60%) 102,384
Vince (₱170,649 x 40%) . 68,256 170,640
Net Income Distribution ₱349,260 ₱250,740 ₱600,000

Computation of bonus to Ralph:

Net income of the Partnership ₱600,000
Less: Salaries of Partners ₱360,000
Interest on partners’ average capital 50,400 410,400
Net income after salary and interest nut 189,600
before bonus
Multiply: Bonus Rate 10%
18,960
Computation of the balance/remainder:
Net income of the Partnership ₱600,000
Less: Salaries of Partners ₱360,000
Interest on partners’ average capital 50,400
Bonus 18,960 427,360
Net income after salary and interest but 170,640
before bonus

Case 2. Bonus is based on net income after deducting salaries, interest (if any)
and bonus.

Assume that Ralph and Vince agreed to the following:

a. Each of them would have a salary of ₱15,000 per month one-year operation;
b. 12% interest on their respective average capital;
c. 10% bonus of net income after salaries, interest on capital and bonus to Ralph, the
managing partner; and
d. The balance of net income shall be divided on the basis of 60% and 40%,
respectively.

The average capital balances of Ralph and Vince are ₱262,500 and ₱157,500,
respectively. The distribution of ₱600,000 profit would be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Ratio on the remaining balance 60% 40% 100%
Salary of each partner (₱15,000 x 12) ₱180,000 ₱180,000 ₱360,000
12% interest on the average capital
Ralph (₱262,500 x 12%) 31,500
Vince (₱157,500 x 12%) 18,900 50,400
Bonus to Ralph 17,236 17,236
Distribution of Balance/Remainder:
Ralph (₱172,364x 60%) 103,418
Vince (₱172,364x 40%) . 68,946 172,364
Net Income Distribution ₱349,260 ₱250,740 ₱600,000

Computation of bonus to Ralph:

Net income of the Partnership ₱600,000
Less: Salaries of Partners ₱360,000
Interest on partners’ average capital 50,400 410,400
Net income after salary and interest but 189,600 110%
before bonus
Less: Bonus 17,236 10%
Net income after salary and interest and 172,364* 100%
bonus

Computation of the balance/remainder:

Net income of the Partnership ₱600,000
Less: Salaries of Partners ₱360,000
Interest on partners’ average capital 50,400
Bonus 17,236 427,636
Net income after salary and interest and 172,364*
bonus

Accounting for Interests and Salaries Treated as Expenses

Payments of interest on capital or salaries to partners are considered an

allocation of profit and are usually not expense on the income statement.

In an attempt to emulate corporate financial reporting, however, som

partnerships with adequate disclosure, do display part or all of such payments
as expenses in the income statement to determine the true performance of the
business.

When interests on capital and salary are treated as ordinary operating expense,
they are first deducted from the partnership net income prior to the profit, and
loss distribution to partners.

ILLUSTRATION

Ralph and Vince agreed that each of them will receive a ₱20,000 monthly
salary their respective capital balance is to earn 6% interest per year, and the
remaining balance of profit is to be shared equally.

Assume the following results of operations of Ralph Vince Partnership for an

accounting year:

Sales ₱ 2,000,000
Cost of sales 800,000
Rent expense 150,000
Supplies expense 100,000
Depreciation expense 40,000
If the partners agreed that their salaries and interest on capital are to be
treated as operating expense and their capital balances are ₱200,000 and
₱300,000, respectively, compute and journalize the profit distribution.

Computation and distribution of profit

Sales ₱ 2,000,000
Less: Cost of sales 800,000
Gross income 1,600,000
Salaries (₱20,000 x 12 x 2) ₱480,000
Rent Expense 150,000
Supplies Expense 100,000
Depreciation Expense 40,000
Interest ((₱200,000 x 6%) + (300,000 x 30,000 800,000
6%))
Net Income 800,000
Profit Distribution:
Ralph (800,000/2) 400,000
Vince (800,000/2) 400,000

GENERAL JOURNAL

(Ralph Vince Partnership)

Date Descriptions Debit Credit
6/30Income Summary ₱800,000
Ralph, Capital ₱400,000
Vince, Capital 400,000
To record profit distribution for Ralph and Vince.

Distribution of Insufficient Net Income

As a rule, the prescribed allocation for salaries and/or interests on capital

balances should still be given in spite of the insufficiency of the partnership's
net income to cover them.

The earnings deficiency produced as a result of giving salaries and/or interests

shall be allocated among the partners based on their profit and loss sharing
ratio.

ILLUSTRATION

Ralph and Vince have average capital balances in their partnership amounting
to ₱320,000 and ₱480,000, respectively. They agreed to have a profit and loss
distribution of 60% and 40%, respectively
They work in the partnership and agree to have a salary of ₱24,000 each per
month and that their respective average capital balances shall be given an
interest of 6% per year.

During a calendar year operation, the partnership earned a net income of

₱400,000. How would the profit be distributed if Vince, the managing partner,
shall receive a bonus of 10% based on net income before salaries and interest
on average capital?

The distribution of the net income of the partnership shall be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Ratio on the remaining balance 60% 40% 100%
Salary of each partner (₱24,000 x 12) ₱288,000 ₱288,000 ₱576,000
Interest on the capital
Ralph (₱320,000 x 6%) 19,200
Vince (₱480,000 x 6%) 28,800 48,000
Bonus to Vince (₱400,000 x 10%) 40,000 40,000
Distribution of Remainder: (deficit of
(264,000))
Ralph ((264,000) x 60%) (158,400)
Vince ((264,000) x 40%) . (105,600) (264,000)
Net Income Distribution ₱188,800 ₱211,200 ₱400,000

Computation of the balance/remainder:

Net income of the Partnership ₱400,000
Less: Salaries of Partners ₱576,000
Interest on partners’ average capital 48,000
Bonus 40,000 (664,000)
Net income after salary, interest and bonus (264,000)

TEACHER’S INSIGHT

Ø Notice that the bonus is still given to the managing partner regardless of the deficit
in the net income after deducting salaries and salaries, this is because of the
agreement that the bonus is based on the net income before deducting salary, interest
and bonus. However, if the bonus is based on the net income after deducting salary
and interest, there will be no bonus given to Vince because the net income cannot
already cover the bonus.
Distribution of Partnership Losses

If there were partnership net loss, the partners' salaries and interests on capital
shall still be given to them. However, the bonus to the managing partner shall
be forfeited because bonuses are given as incentives for earnings, not for
losses

ILLUSTRATION

Ralph and Vince have average capital balances in their partnership amounting
to ₱320,000 and ₱480,000, respectively. They agreed to have a profit and loss
distribution of 60% and 40%, respectively

They work in the partnership and agree to have a salary of ₱24,000 each per
month and that their respective average capital balances shall be given an
interest of 6% per year.

During a calendar year operation, the partnership earned a net loss of

₱400,000. How would the profit be distributed if Vince, the managing partner,
shall receive a bonus of 10% based on net income before salaries and interest
on average capital?

The distribution of the net income of the partnership shall be:

Ralph Vince Partnership

Profit Distribution Schedule

December 31, 2020

Ralph Vince Total
Ratio on the remaining balance 60% 40% 100%
Salary of each partner (₱24,000 x 12) ₱288,000 ₱288,000 ₱576,000
Interest on the capital
Ralph (₱320,000 x 6%) 19,200
Vince (₱480,000 x 6%) 28,800 48,000
Distribution of Remainder: (deficit of
(264,000))
Ralph ((1,024,000) x 60%) (614,400)
Vince ((1,024,000) x 40%) . (409,600) (1,024,000)
Net Income Distribution ₱307,200 (₱92,800) (₱400,000)

GENERAL JOURNAL

(Ralph Vince Partnership)

Date Descriptions Debit Credit
6/30Ralph, Capital ₱307,200
 Vince, Capital 92,800
Income Summary ₱400,000
To record the loss distribution for Ralph and
Vince.

TEACHER’S INSIGHT

· The partners share in the profits and losses of a partnership in the

accordance with their partnership agreement.

· If only the share of each partner in the profits has been agreed upon,
the share of each in the losses shall be in the same proportion.

· In the absence of stipulation, the share of each partner in the profits

and losses shall be in proportion to what he may have contributed, but the industrial
partner shall not be liable for losses.

· Before allocation of profit, the following items are allocated firs, if

they are stipulated in the partnership agreement: (a) salaries, (b) bonuses to partners
(allocated only if there is profit), and (c) interest on capital. After allocating these
items, any remaining profit or loss is allocated based on the stipulated P/L ratio.