ACCOUNTING FOR PARTNERSHIPS Partnership Operations and Financial Reporting William H. “Bill” Gates Ill and Paul Allen icrosoft Co-founders in 1975 Gates, 52, married, 3 children, Forbes 2008 Ranked 3, net worth US$S8 billion. He was No. 1 for 13 years. He slipped two spots after Warren Buffett and Carlos Slim Helu, Microsoft's chief visionary is moving further away from day-to-day corporate work. For ie frst time did not offer a strategy outiook at this year's financial analyst meeting. instead, prefers to dive into innovative projects, foster collaboration among Microsoft's many divisions. Microsoft aims to be omnipotent, selling software for PCS, servers, cel Phones, television set-top boxes, gaming consoles and the Web. Fifteen product taunches slated for the next year and a half, including new version of Windows, called Vista, and gaming console Xbox 360. Af the ripe (tech sector) age of 30, Gates’ company impressively beats rivals in profit margins, market capitalization and R&D budget, but its sales growth is slowing to a (recently) single-digit percentage pace. Gates methodically diversifying wealth: sells 20 million shares each quarter, reinvests through Cascade Investment in non-tech ‘companies. He has big stakes in Canadian National Railway, Republic Services, Berkshire Hathaway. Soldiering on after losing billions in value of stocks and a historic antitrust trial in the Previous years. Even the worst-case may not be that bad, John D. Rockefeller only got wealthier after the government busted up his Standard Oil in 1911, Meantime, there's plenty to keep Gates occupied outside the courtroom. Microsoft's Fevenues and earings growth are slowing, bogged down by lackluster sales of newest Windows operating system. Investors seemed unimpressed with software giant's Internet ambitions: a USS4.4 billion plan to roll out Microsoft.Net, a subscription-based web service. And a pesky competitor hires detectives to investigate his business Long ridiculed for his low level of giving, the world’s richest man is now the most charitable. ‘The US$29.0 billion Bill and Melinda Gates Foundation donates money to slobal health care and education (high school), specifically disease prevention (hepatitis 8, AIDS, malaria) and vaccine development. 2Allen, 55, single, net worth US$16 billion, Forbes 2008 Ranked 41. Microsoft co-founder has carefully built a multimedia empire. He sold huge chunks his stake in Microsoft to finance his wired-world investment strategy, in which he pl to create and distribute broadband content. Places bets through his Vulcan Ventu which has made 140 investments in early stage Internet and telecom compani Recently, claims to have liquidated 75% of the diverse equity holdings in pri investment firm, Vulcan Ventures, reinvesting much in U.S. Treasury paper. Left Microsoft in 1983, to fight Hodgkin's disease and rejoined the board of Microsoft 1990 after the disease went into remission. Owns the NBA basketball team, Portland Trailblazers and professional football's Seattle Seahawks. Allen launc! charitable foundations for education, medical research, the arts and environmer conservation. The net worth of these two great wealth accumulators are simply unimaginable Philippine standards. Their informal programming partnership started in the 1970s. Gates and Allen are pioneers in the production of vaporware. Vaporware to the tactic to announcing a software product before it exists, typically to discou rivals from proceeding with development of competing versions. In 1975, they have developed a product to license—BASIC (Beginners’ AllPur ‘Symbolic Instruction Code), which is an easy-to-learn programming language. Gates = Allen formed a partnership, initially called “Micro-Soft” (short for “microcomp\ software”). Profits were to be split 60:40. Later amended to 64:36 with Gates recei the larger share in recognition of his greater contribution to the original development: the BASIC software. Gates eventually dropped out of Harvard to work full time at Microsoft. Within 2 of Microsoft's founding, its BASIC program had effectively become the standard microcomputers. Now, the Microsoft's creed of “A computer on every desk and in home, running Microsoft software” is coming into fruition. In 1990, the Windows, became the hottest software product of all time, selling a million copies within months. Several Windows versions and Microsoft Offices later; as they say, the rest history! Adapted from: Forbes Asia, Top Five of The 400 Richest People in America, Fo Global, Special 2008, 2007, 2005, 2002 & 2000 Issue and How To Be A Billionaire by Martin, Fridson. ‘What are the factors to be considered in arriving ata plan for dividing profits or losses the case of Gates and Allen (assuming they did not incorporate at the outset)? In instant case, Gates has the net worth of USD 58 billion while Allen has USD 16 bill ‘one reason being their sharing is in the ratio of 64:36.Should capital investment be given more weight than technical contribution with regard to the formulation of the Profit-sharing scheme? If there is no agreement as to how Profits oF losses will be shared, then whee ‘ules will apply? Assuming there i= an lesen nt, what are the common arrangements 10 overn the distribution of profits or losses? There are partnerships that allow salary allowances, bonus, and/or interest on Partners’ capital balances. Why are these techniques resorted to? of a partner in the net assets of the part Partner's share in profits or losses. Mlustration. “Nelson Daganta is a One-third partner” is an ambiguous statement. ave one-third equity in the net assets of the Partnership but might have a Share in the profit or loss of the firm. Suen a statement may also be lean that Daganta is e of the profit or loss, although Money, Property or industry Partnership profits are realized as a result of putting together the contributions— money, Property or industry—of the partners, ‘The amount of capital invested by each Partner, the amount of time each partner devotes! to the business and other Sontiibutions are the factors being considered in the formulation of an equitable proft and loss ratio.2. A partner who is well known in a profession or an industry may contri immensely to the success of the partnership although he may not partic actively in the operations of the partnership. These two factors may be incorporated in the plan to arrive at a ratio by which remaining profits or losses are to be divided. Illustration. Leo Paolo Perez and Luzviminda Barros are partners in a car care busir Partner Leo Paolo Perez contributed most of the assets of the business but spends I time for its daily operations. On one hand, Partner Luzviminda Barros contributed in assets but devotes his full knowledge and attention to the partnership. To di profits or losses based on capital contributions alone will result to iniquities. The pi and loss sharing agreement should have considered the provision of salaries or recognition of the talent and time being contributed by Partner Luzvimi Performance Methods Many partnerships use profit and loss sharing arrangements that give some weigl the specific performance of each partner to provide incentives to perform well allocation of profits to a partner on the basis of performance is frequently referred a bonus. Examples of the use of performance criteria are: 1. Chargeable hours. These are the total number of hours that a partner incurre: client-related assignments. Weight may be given to hours in excess of a standat 2, Total billings. The total amount billed to clients for work performed and super by a partner constitutes total billings. Weight may be given to billings in exc norm. 3. Write-offs. Consist of uncollectible billings. Weight may be given to a wri percentage below a norm. Promotional and civic activities. Time devoted to developing future business 4. enhancing the partnership name in the community is considered promotional civic activity. Weight may be given to time spent in excess of a norm or to accomplishments resulting in new clients 5, Profits in excess of specified levels. Designated partners commonly receive a c percentage of profits in excess of a specified level of earnings. RULES FOR THE DISTRIBUTION OF PROFITS OR LOSSES The profits or losses shall be distributed in conformity with the agreement. If on share of each partner in the profits has been agreed upon, the share of each in losses shall be in the same proportion. In the absence of stipulation, the sharé of each partner in profits of losses shall proportion to what he may have contributed (according to the ratio of original 24investments or in its absence, the ratio of capital balances at the beginning of the year), but the industrial partner may not be liable for the losses. As for the profits, the industrial partner shall receive such share as may be just and equitable under the circumstances. If aside from his services he has contributed capital, he shall also receive a share in the profits in proportion to his capital (Civil Code of the Philippines, Article 1797), A stipulation which excludes one or more partners from any share in the profits or losses is void (Article 1799). The Partnership must exist for the common benefit or interest of the partners. A summary of the above legal provisions is prepared as follows: 1. Profits a. the profits will be divided according to partners’ agreement. b. if there is no agreement: > as to capitalist partners, the profits shall be divided according to their capital contributions (according to the ratio of original capital investments or in its absence, the ratio of capital balances at the beginning of the year). as to industrial partners (if any), such share as may be just and equitable under the circumstances, provided, that the industrial partner shall receive such share before the capitalist partners shall divide the profits. 2. Losses the losses will be divided according to partners’ agreement. if there is no agreement as to distribution of losses but there is an agreement as to profits, the losses shall be distributed according to the profit sharing ratio. in the absence of any agreement: > as to capitalist partners, the losses shall be divided according to their capital contributions (according to the ratio of original capital investments or in its absence, the ratio of capital balances at the beginning of the year). as to purely industrial partners (if there’s any), shall not be liable for any losses. The industrial partner is not liable for losses because he cannot withdraw the work or labor already done by him, unlike the capitalist partners who can withdraw their capital. In addition, if the partnership failed to realize any profits, then he has labored in vain and in a real sense, he has already contributed his share in the loss.CORRECTION OF PRIOR PERIOD ERRORS Any business entity will from time to time discover errors made in the measurement of profit in prior accounting periods. Good internal control and the exercise of due care should serve to minimize the number of financial reporting errors that occur; however, these safeguards cannot be expected to completely eliminate errors in the financial statements. Per International Accounting Standards (IAS) No. 8, Accounting Policies, Changes in Accounting Estimates and Errors, prior period errors are omissions from and other misstatements of the entity's financial statements for one or more prior periods that are discovered in the current period. Errors may occur as.a result of mathematical mistakes, mistakes in applying accounting policies, misinterpretation of facts, fraud or oversights. Examples include errors in the estimation of depreciation, errors in inventory valuation, and omission of accruals of revenue and expenses. Material prior periods must be restated to report financial position and results of operations as they would have been presented had the error never taken place. The amount of the correction of a prior period error that relates to prior periods should be reported by adjusting the opening balances of partners’ equity and affected assets and liabilities. The correction of a prior period error is excluded from profit or loss for the period in which the error is discovered. Fan error resulted in an understatement of profit in previous periods, a correcting entry would be needed to increase Capital. If an error overstated profit in prior periods, then Capital would have to be decreased. The effect of the error correction will be divided based on the applicable profit and loss ratio. DISTRIBUTION OF PROFITS OR LOSSES BASED ON PARTNERS’ AGREEMENT In general, profits or losses shall be divided in accordance with the agreement of the Partners. The ratio in which profits or losses from partnership operations are distributed is recognized as the profit and loss r ‘The partners may agree on any of the following scheme in distributing profits or losses: 1, Equally or in other agreed ratio 2. Based on partners’ capital contributions ratio of original capital investments ratio of capital balances atthe beginning of the year ratio of capital balances at the end ofthe year ratio of average capital balances a By allowing interest on partners’ capital and the balance in an agreed ratio By allowing salaries to partners and the balance in an agreed ratio 26By allowing bonus to the managing partner based on profit and the balance in an agreed ratio By allowing salaries, interest on partners’ capital, bonus to the managing Partner and the balance in an agreed ratio (combination of 3 to 5) ‘Note that the partners can agree on not using a residual sharing ratio (“the balance in an agreed ratio) if profits do not exceed the total salary and interest allowances. In such a case, the partners must agree on the priority of the various profit or loss distribution schemes, iMlustration. The following series of illustrations are based on the figures obtained from the Detoya and Gevera Partnership which had a profit of P300,000 for the year ended Dec. 31, 2008, the first year of operations. The partnership contract provided that each Partner may withdraw P5,000 on the last day of each month; both partners did so. during the year. The drawings are recorded by debits to the partners’ drawing accounts and shall not be considered in the division of profit or loss. It is the intention of the partners that each partner's share in the profit or loss be either credited or debited to the drawing account. Gloria Detoya invested P400,000 on Jan. 1, 2008 and an additional P100,000 on April 1. Esterlina Gevera invested P800,000 on Jan. 1 and withdrew P50,000 on July 1. These. transactions and events are summarized in the following capital, drawing and income summary ledger accounts: Gloria Detoya, Capital Esterlina Gevera, Capital Jan.1 400,000 July1 50,000 | Jana 800,000 ‘Apr.1 100,000 Gloria Detoya, Drawing Esterlina Gevera, Drawing Jan, «Dee. 60,000 Jan. Dee. 60,000 Income Summary Dec. 31 300,000 Equally or in other Agreed Ratio Partnership contracts may provide that profit or loss be divided equally. The profit of 300,000 for the Detoya and Gevera Partnership is transferred by a closing entry on. Dec. 31, 2008, from the income summary ledger account to the partners’ drawing accounts: Income summary 300,000 Gloria Detoya, Drawing Esterlina Gevera, Drawing To record the division of profits.If the partnership had a loss of P200,000 for the year ended Dec. 31, 2008, the income summary ledger account would have a debit balance of P200,000. This loss would be transferred to the partners’ drawing accounts by a debit to each drawing account for 100,000 and a credit to the income summary account for P200,000. Gloria Detoya, Drawing 100,000 Esterlina Gevera, Drawing 100,000 Income Summary 200,000 To record the division of losses. Assume instead that Detoya and Gevera share profits and losses in a ratio of 60:40 and profit was P300,000, the profit would be divided as follows: Income Summary 300,000 Gloria Detoya, Drawing Esterlina Gevera, Drawing To record the division of profits. Computation: Detoya: 60% x P300,000 Gevera: 40% x P300,000 Based on Partners’ Capital Contributions Division of partnership profits in proportion to the capital invested by each partner is ‘most likely to be found in partnerships in which substantial Investments is the principal ingredient for success. It is essential that the partnership contract be specific with respect to the concept of capital. Capital may refer to either of the following: Ratio of Original Capital Investments. Assume that the partnership agreement provides for the division of profits in the ratio of original capital investments. The original investments of Detoya and Gevera are P400,000 and P800,000, respectively. The profit ‘of P300,000 for 2008 is divided as follows: Income Summary 300,000 Gloria Detoye, Drawing Esterlina Gevera, Drawing To record the division of profits. Computation: Detoya: 300,000 x P400,000/2,200,000 100,000 Gevera: P300,000 x P800,000/P1,200,000 200,000 12300,000 After the entry allocating the profits of P300,000 to Detoya and Gevera, are the partners supposed to receive cash for their respective share in the profits? No, the partners’agreement provided for the beginning of the year. In this balances at the beginning of t ‘Operations. The profit of P300, Income Summary Gloria Detoya, Drawing Esterlina Gevera, Drawing To record the division of profits. Computation: Detoya: P300,000 x P400,000/P1,200,000 ‘Gevera: P300,000 x P800,000/P1, 200,000 Income Summary Gloria Detoys, Drawing Esterlina Gevera, Drawing To record the division of profits, ‘Computation: Detoya: P300,000 x P500,000/61,250,000 ‘Gevera: P300,000 x P750,000/P1, 250,000 180,000 300,000 Ratio of Average Capital Balances. Division of Profits or losses on the basis of the three Preceding capital concepts—original capital Investments; capital balances at the Peginning of the year; or capital balances at the end Of the year—may prove inequitable if there are material changes in the capital accounte during the year. ‘When beginning capital balances are used in allocating profits, additional investments during the year are discouraged because the partners making such investments are not Compensated in the division of profits until the next year,preferable because It reflects the capital actually available for use by the partnership during the year. The agreement should also state the amount of drawings each partner may make. These drawings are considered temporary and are recorded as debits to the partner's, drawing account. Drawings within the allowable amount will not affect the computation of the average capital balance. On the contrary, drawings in excess of the allowable amount are considered permanent reductions in capital; hence, the computation of the average capital balance is affected. In the continuing illustration for the Detoya and Gevera Partnership, the partners are entitled to withdraw P5,000 monthly or a total of P60,000 per annum. Any additional withdrawals are directly debited to the partners’ capital accounts and therefore will affect the computation of the average capital ratio. Detoya and Gevera Computation of the Average Capital Balances For the year ended Dec. 31, 2008 Gloria Detoya, Capital Capital Account Portion* ofthe Average Capital Balances Year Unchanged Balances 400,000 a2) 100,000 500,000 9/12 375,000 ‘Average Capital Esterlina Gevera, Capital Pg00,000 x 6/12 400,000 750,000 x 6/12 375,000 ‘Average Capital 775,000 Total Average Capital Balances 2,250,000 “The fractions-for each partner should add up to 12/12 oF 1, This convention will help ‘minimize counting errors as to the number of months the capital balance went unchanged. To state the obvious, there are only 12 months ina year. For example, for Partner Detoya, the fraction will total to 12/32 [3/12 + 9/12 = 12/12} or in simple terms, 1 The entry to record the division of P300,000 profits is as follows: Income Summary 300,000 Gloria Detoya, Drawing 114,000 Esterlina Gevera, Drawing 186,000 To record the division of profits.‘Computation: Detoya: 300,000 x P475,000/P1,250,000 114,000 Gevera: P300,000 x P775,000/P1,250,000 186,000 ‘P309,000 By Allowing Interest on Capital and the Balance in an Agreed Ratio in the preceding section, the plan for dividing the total profits in the ratio of partners capital balances was based on the assumption that capital investments were the controlling factor in the success of the partnership. However, itis not always the case. Consequently, partnerships may choose to allocate a portion of the total Profits in the capital ratio and the balance equally or in other agreed ratio after due consideration of the partners’ other contributions, To allow interest on partners! capital account balances is almost similar to dividing part of profits in the ratio of partners’ capital balances. if the partners agree to allow interest on capital as a first step in the division of profit, they should specify the interest. {ate to be used. It should also state whether interest is to be computed on capital balances on specific dates or on average capital balances during the year. Partners invested in a partnership for profits, not for interest. The interest on partners’ ‘capital, along with the other profit sharing plans to be discussed in the temainder of the chapter, are to be considered as mere techniques to share partnership profits or losses equitably and not as expenses of the partnership. ‘On the other hand, the interest on loans from partners is recognized as expense and a factor in the measurement of profit or loss of the partnership. Similarly, interest earned ‘on loans to partners is recognized as partnership income. This treatment is consistent with the discussion in Chapter 1 that loans receivable from or payable to partners are assets and liabilities, respectively, of the partnership. Continuing the illustration of Detoya and Gevera Partnership with ¢ profit of P300,000 for 2008 and capital balances as already shown, assume that the partnership agreement allowed 15% interest on average capital account balances, with the balance to be divided equally. The profit of P300,000 for 2008 is divided as follows: Detoya Gevera Total 15% Interest on Average Capital: Detoya: P475,000x15% P 71,250 Gevera: P775,000x 15% P116,250, Subtotal 187,500 Balance to be Divided Equally {300,000 - P187,500 = P112,500): Detoya: P112,500 x 50% 56,250 Gevera: P112,500 x50% 56250 112,500 ‘Share of Partners in Profits 127,500 P172,500,__P300,000 EL P172, 500 __ 300,000 at‘The journal entry to close the income summary ledger account on Dec. 31, 2008 follows: Income Summary 300,000 Gloria Detoya, Drawing 327,500 Esterlina Gevera, Drawing 172,500 ‘To tecord the division of profits. ina related case, assume that the Detoya and Gevera Partnership had a loss of 10,000, for the year ended Dec. 31, 2008. ifthe partnership agreement provided. {for interest on Capital accounts, this provision must be honored regardless of whether operations yielded profits or not. S ers in the same manner as the P300,000 profit. The 10 would still be given to the partners. The only 1 losses after the interest allowances would 500 which will be divided equally betwee: ‘The {oss will be shared by the partn total interest allowance of P187,50 difference is that the division of profits of involve a larger negative amount of P197, Detoya and Gevera: Detova Gevera Total 15% interest on Average Capital: Detoya: P475,000 x 15% P 71,250 * Gevera: P775,000x 15% 116,250 Subtotal 187,500 Balance to be Divided Equally {[(P10,000) - P187,500 = P(197,500)}: Detoya: P(197,500) x 50% (98,750) Gevera: (197,500) x 50% (98,750) Subtotal (297,500) ‘Share of Partners in Profits (Losses) p(27,500)_P.27,500_ (10,000) ‘The journal entry to close the income summary ledger account on Dec. 31, 2008 folloy Gloria Detoya, Drawing, 27,500 20,000 Income Summary Esterlina Gevera, Drawing 17,500 ‘To record the division of losses, ‘after intial consideration, the idea that a loss of P10,000 should cause one pert Capital to increase and the other partner's capital to decrease TY api tmessonable. However, this result was planned and was with good reason: Par Govern invested more capital than Partner Detoya; this capital was used to calhy operations, and the partnership's incurrence of a loss in the first year is no reasor disregard Gevera's larger capital investment.Comparison of distribution based solely on capital ratios as against distribution with interest on capital balances. There will be a significant difference between the two distribution plans ifthe partnership is operating at a loss. Under the capital ratio plen, the partner who invested more capital will ultimately shoulder a bigger share of the loss. This result may be considered inequitable because the investment of capital presumably is not the cause of the loss. tinder the interest plan, the partner who invested more capital is credited (increased) for an interest on his capital and is ultimately debited (decreased) with a lesser share of tthe loss; in some cases, the result may even be a net credit (increase). By Allowing Salaries to Partners and the Balance in an Agreed Ratio ‘The sharing agreement may provide for variations in compensating the personal Services contributed by partners. Even among partners who devote equal service time, one partner's superior experience and knowledge may command a greater share of the Profit. To acknowledge the harder working or more valuable partner, the profit-sharing plan may provide for salary allowances. The partnership agreement should be clear on the treatment of salary allowances when losses are Incurred. In the absence of an agreement to govern this situation, solary allowances will be provided even when operations yielded losses. This allowance should not be confused with salaries expense or with the partner's drawing account which is debited for periodic salary allowances. The cash withdrawals will in no way affect the division of profits; the division of profits is governed by the sharing agreement. Partners are the partnership's owners; they are not employees of the business, if Partners devote their time and services to the affairs of the partnership, they are understood to do so for profit, not for salary. Therefore, when the partners calculate the profit of the partnership, salaries to the partners are not deducted as expenses in the statement of recognized income and expense. Continuing the illustration for the Detoya and Gevera Partnership, assume that the Partnership agreement provided for an annual salary of P100,000 to Detoya and 60,000 to Gevera, and the balance to be divided equally. The profit of 300,000 for 2008 is divided as follows: Detove Gevera. «Total Salary Allowances 100,000 P 60,000 —-P160,000 Balance to be Divided Equally {P300,000 - P160,000 = P140,000}}: Detoya: P140,000 x 50% 70,000 Gevera: P140,000 x 50% 70,000 __140,000 Share of Partners in Profits P170,000__P130,000__P300,000 009 300,000The journal entry to close the income summary ledger account on Dec. 31, 2008 follow: Income Summary 300,000 Gloria Detoya, Drawing 170,000 Esterlina Gevera, Drawing 130,000 To record the division of profits. By Allowing Bonus to the Managing Partner Based on Profit and the Balance in an Agreed Ratio ‘A partnership contract may provide for a special compensation in the form of bonus the managing partner when the results of operations of the partnership are favoral ‘This allowance is given in order to encourage the partner to maximize the pro} potentials of the partnership. Bonus is not being considered in the computation profit, rather it is a mere technique to distribute profits. ‘Assume that the Detoya and Gevera Partnership agreement provided for a bonus 25% of profit before bonus to Partner Detoya and the balance to be divided equal The profit is P300,000. Detova Gevera Total Bonus [25% x P300,000 |: 75,000 P 75,000, Balance to be Divided Equally [P300,000 - P75,000 = P225,000)): Detoya: P225,000% 50% 312,500 Gevera: P225,000 x 50% 112,500 __ 225,000 Share of Partners in Profits p187,500__P112,500_P300,000 ‘The journal entry to close the income summary ledger account on Dec. 31, 2008 folio Income Summary 300,000 Gloria Detoya, Drawing 187,500 Esterlina Gevera, Drawing 112,500 To record the division of profits. ‘Assume instead that the Detoya and Gevera Partnership agreement provided f bonus of 25% of profit after bonus to Partner Detoya and the balance to be divi equally. It is understood in the wording of the agreement that the 25% bonus wil based on the difference after deducting bonus from 2 certain amount. This ce ‘amount is the profit after considering all the operating expenses but before this bon Here, the P300,000 profit stil includes the bonus. The difference between this and bonus shall be the basis for the.25% bonus rate. Hence, profit after bo represents 100% while the profit of P300,000 before bonus represents 125%. 244Profit before Bonus 300,000 125% Profit after Bonus (P300,000/125%) 240,000_100% Bonus, P 60,000 25% Detoya Gevera Total Bonus 60,000 P 60,000 Balance to be Divided Equally { 300,000 - P60,000 = 240,000): Detoya: P240,000 x 50% 120,000 Gevera: P240,000 x 50% 120,000 240,000 ‘Share of Partners in Profits 180,000 120,009 __P300,000 0,000 P300,000 ‘The journal entry to close the income summary ledger account on Dec. 31, 2008 follows: Income Summary 300,000 Gloria Detoya, Drawing 180,000 Esterlina Gevera, Drawing 120,000 To record the division of profits. By Allowing Salaries, Interest on Capital, Bonus to the Managing Partner and the Balance in an Agreed Ratio The service contributions and capital contributions of the partners are often not equal. If the service contributions are not equal, salary allowances can compensate for the differences. Or, when capital contributions are not equal, interest allowances can make up for the unequal investments. When both service and capital contributions are unequal, the allocation of profits or losses may include salary allowances, interest on their capital balances, bonus to the managing partner, and the balance to be divided in an agreed ratio. Note that the provisions for salaries and interest in the partnership agreement are called allowances. These allowances are not reported in the statement of recognized income and expense as salaries and interest expense; they are merely means of allocating profit to the partners. Assume that the profit for the year is P400,000 and the partnership agreement for the Detoya and Gevera Partnership provided for the following: 1. Bonus to Detoya of 25% of profit after salaries and interest but before bonus; 2. Annual salaries of P100,000 to Detoya and P60,000 to Gevera; 3. Interest on average capital balances of P71,250 and P116,250 to Detoya and Gevera, respectively; 4. Balance to be divided in a ratio of 40:60.Detova Gevera Total Salary Allowances 100,000 60,000 P160,000 Interest on Average Capital Balances 71,250 116,250 187,500 Bonus [ 25% (P400,000 - P100,000 - 13,125 13,125 60,000 - 71,250 - P116,250) |: Balance to be Divided in a Ratio of ‘40:60 [ 400,000 - P160,000 ~ 187,500 - P13,125 = P39,375]: Detoya: P39,375 x 40% 15,750 Gevera: P39,375 x60% 23,625 39,375 Share of Partners in Profits 200,125 _P199,875 _P400,000 The journal entry to close the Income summary ledger account on Dec. 31, 2008 follows: Income Summary 400,000 Gloria Detoya, Drawing 200,125, Esterlina Gevera, Drawing 199,875 To record the division of profits. ‘Assume instead that the bonus to Detoya is 25% of profit after salaries, interest and after bonus. The computation of the bonus follows: Profit before Salaries, Interest and Bonus 400,000 Less: Salaries 160,000, Interest 187,500 _347,500 Profit after Salaries and interest but before Bonus 52,500 125% Profit after Salaries, Interest and after Bonus* 42,000 100%, Bonus P 40,500 __25% '=p52,500 divided by 125% = P42,000. Detova —Gevera_ Total Salary Allowances 100.000 60,000 160,000 Interest on Average Capital Balances 71,250 116,250, 187,500 Bonus 10,500 10,500 Balance to be Divided in a Ratio of ‘40:60. [400,000 - P160,000 187,500 - P10,500 = P42,000): Detoya: 42,000 x 40% 16,800 Gevera: P42,000 x 607% =25,200__ 42,000 Share of Partners in Profits 198,550 __P201,450_P400,000.‘The journal entry to close the income summary ledger account on Dée. 31, 2008 follows: Income Summary 400,000 Gloria Detoya, Drawing 198,550 Esterlina Gevera, Drawing 201,450 To record the division of profits fs Some of the topics below are required inclusions in this subject per Commission on Higher Education Memorandum Order No. 3 (series of 2007), As Amended. Unfamiliar ferms in the succeeding discussions which are partly based on IAS No. 4 (revised 2007) will be fully appreciated in higher accounting subjects. Suffice it to say, though, that at this point you're in a better situation than the users of other textbooks. The International Accounting Standards Board (IASB) issued a revised international Accounting Standards (IAS) No. 1, Presentation of Financial Statements last Sept. 6, 2007. This standard supersedes the 2003 version of AS 1 as amencied in 2005. IAS No. 4 (revised 2007) is effective for periods beginning on or after 1 January 2009, although earlier application is permitted. FINANCIAL REPORTING Purpose of Financial Statements Financial statements are a structured representation with the objective of providing information about the financial position, financial performance and cash flows of on entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of the management's stewardship of the resources entrusted to it, To meet the objective, financial statements provide information about an entity's assets, liabilities, equity, income and expenses, other changes in equity and cash flows. Overall Considerations Fair Presentation and Compliance with Intemational Financial Reporting Standards lWRss). The financial statements shall present fairly the financial position, financial Performance and cash flows of the entity. Fair presentation requires the faithful Fepresentation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the IASB’s Framework. Under IAS No. 1 (revised 2007), entities are required ‘to make an explicit and unreserved statement of compliance with IFRS in the notes. Going Concern. Financial statements should be prepared on a going concern basis unless management intends to liquidate the entity or cease trading or has no realistic ‘option but to do so.‘Accrual Basis of Accounting. An entity shall prepare its financial statements, except for: cash flow information, using the accrual basis of accounting. Materiality and Aggregation. An entity shall present separately each material class of similar items. Material items that are dissimilar in nature or function should be separately disclosed, Offsetting. An entity shall not offset assets and liabilities, income and expenses unless required or permitted by an IFRS. Frequency of Reporting and Comparative Information. At least annually, an entity shall present with equal prominence each financial statement in a complete set of financial statements including comparative information in respect of the previous period for all ‘amounts reported in the current period’s financial statements. Consistency of Presentation. An entity shall retain the presentation and classification. items in the financial statements in successive periods unless an alternative would be more appropriate or an IFRS requires a change in presentation. Identification of the Financial Statements. An entity shall clearly identify the financial statements and distinguish them from other information in the same published document. international Financial Reporting Standards (IFRS) apply only to the financial statements and not necessarily to other information presented in an annual report, regulatory filing or another document. ‘An entity shall clearly identify each financial statement and the notes. An entity shel display the following information prominently: ‘® name of the reporting entity; © whether the financial statements are of the individual entity or a group entities; the date of the end of the reporting period or the period covered by the set financial statements or notes; the presentation currency; ‘and the level of rounding used in presenting amounts in the financi statements. Complete Set of Financial Statements Per revised International Accounting Standards (IAS) No. 1, Presentation of Financic Statements, a complete set of financial statements comprises: a. a statement of financial position as at the end of the period; A b. a statement of comprehensive income for the period; ¢. astatement of changes in equity for the period; a a statement of cash flows for the period; 218notes, comprising a summary significant accounting policies and other explanatory information; and a statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in. its financial statements. ‘Statement of Comprehensive Income The form and content of the income statement of the partnership resemble those of the sole proprietorship with the exception of the presentation of the division of profits or losses at the lower portion of the statement. Detoya and Gevera Partial Income Statement For the Year Ended Dec. 31, 2008 Profit Division of Profit (equally): Partner Detoya Partner Gevera 150,000 Total 00.000 The components of profit or loss may be presented either as part of a single statement of comprehensive income or in an income statement, as permitted by paragraph 81 of IAS No. 1 (revised 2007). When an income statement is presented, it is part of a complete set of financial statements and shall be displayed immediately before the statement of comprehensive Income. ‘As a minimum, the statement of comprehensive income shall include line items that present the following amounts for the period: Revenue; Finance costs; Share of profit or loss of associates and joint ventures accounted for Using the equity method; |. Tax expense; e. Asingle amount comprising the total of: The post-tax profit or loss of discontinued operations; and, ‘The post-tax gain or loss recognized on the measurement to fair value less costs to sell on the disposal of the assets or disposal group(s) constituting the discontinued operations;Profit or loss; & Each component of other comprehensive income classified by nature (excluding amounts in (h) below); Share of the other comprehensive income of associates and joint ventures accounted for using the equity method; and 1. Total comprehensive income. ‘Statement of Changes in Equity An entity shall present a statement of changes in equity, showing in the statement: a. total comprehensive income for the period showing separately the total amounts attributable to owners of the parent and to minority interests; for each component of equity, the effects of retrospective restatement Fecognized in accordance with IAS No. 8, Accounting Policies, Changes in Accounting Estimates and Errors; the amounts of transactions with owners in their capacity as owners, showing separately contributions by and distributions to owners; and . for each component of equity, a reconciliation between the carrying amount at the beginning and the end of the period, separately A disclosing each change. The components of equity referred to above include for example, each class of contributed equity, the accumulated balance of each class of other comprehensive income and retained earnings (these are applicable to corporations). The amount of dividends recognized as distributions to owners during the period, and the related ‘amount per share, shall be presented either in the statement of changes in equity or in the notes. In the case of Detoya and Gevera, as contrasted with a sole proprietorship, the number of capital and dray accounts has made the preparation of this statement all the more useful. Changes in an entity’s equity between the beginning and the end of the reporting period reflect the increase or decrease in its net assets during the period. Detoya and Gevera Statement of Changes in Partners’ Equity For the Year Ended Dec. 31, 2008 Detoya Gevera Total Original investments 400,000 800,000 2,200,000 ‘Add: Additional Investments 100,000, - 100,000 Total P500,000 —P800,000_P1,300,000) Less: Permanent Withdrawals 50,000. 50,000 Balances 500,000 P7S0,000__Pi,250,000 220‘Add: Profit: 150,000 __150,000__ 300,000 Total 650,000 P900,000 1,550,000. Less: Temporary Withdrawals 60,000 60,000 _120,000 Partners’ Equity, Dec. 31 {000 840,000 __P1,430,000 Statement of Financial Position After all the components of the statement of comprehensive income along with the changes in partners’ equity for the period have been properly presented, the preparation of the statement of financial position will present no major difficulty. The assets and liabilities will be presented in the statement of financial position as those of a sole proprietorship but the owners’ equity section should exhibit separately the capital balance of P590,000 and P840,000 for Detoya and Gevera, respectively. Though some of the items are not as familiar yet, per revised International Accounting Standards (IAS) No. 1, Presentation of Financial Statements, as a minimum, the face of the statement of financial position shall include ine items that present the following amounts: Property, plant and equipment; Investment property; Intangible assets; Financial assets (excluding amounts shown under e, h and i); Investment accounted for using the equity method; Biological assets; Inventories; Trade and other receivabl Cash and cash equivalents; The total of assets classified as held for sale and assets included in disposal groups classified as held for sale in accordance with IFRS 5; Trade and other payables; Provisions; . Financial liabilities (excluding amounts shown under k and |); Liabilities and assets for current tax, as defined in IAS 12; Deferred tax liabilities and deferred tax assets, as defined in 1AS 12; Liabilities in disposal groups classified as held for sale in accordance with IFRS 5; ‘Minority interest, presented within equity; and Issued capital and reserves attributable to equity holders of the parent. IAS No. 1 (revised 2007) does not prescribe the order or format in which an entity Presents items. The above enumeration (from Paragraph 54 of IAS No. 1, revised 2007) simply provides a list of items that are sufficiently different in nature or function to warrant a separate presentation in the statement of financial position.Note that an entity makes the judgment about whether to present additional items separately on the basis of an assessment of: a. the nature and liquidity of assets; b, the function of assets within the entity; and ¢. the amounts, nature and timing of liabilities. Current and noncurrent assets and liabilities should be separately classified on the face of the statement of financial position except when a presentation based on liquidity provides more reliable and relevant information. ‘An entity shall classify an asset as current asset when it satisfies any of the followi criteria: eit expects to realize the assets, intends to sell or consume it, in its normal operating cycle; or itholds the asset primarily for the purpose of trading; or ‘expects to realize the asset within 12 months after the end of the reporting period; or ‘e the asset is cash or a cash equivalent as defined in 1AS No. 7. ‘All other assets are noncurrent. Operating cycle is the time between the acquisition assets for processing and their realization in cash or cash equivalents. A liability should be classified as a current liability when it: © is expected to be settled in the normal operating cycle; or © isheld primarily for the purpose of trading; or © is due to be settled within 12 months after the end of the reporting period; or © does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. ‘All other liabilities should be classified as non-current liabilities. Statement of Cash Flows ‘The cash flow statement serves as a basis for evaluating the entity's ability to gener: cash and cash equivalents and the needs to utilize these cash flows. The statement of cash flows provides information about the cash receipts and ca payments of an entity during a period. It is a formal statement that classifies ca receipts (inflows) and cash payments (outflows) into operating, investing and financi activities, This statement shows the net increase or decrease in cash during the peri and the cash balance at the end of the period; it also helps project the future net 222flows of the entity. The discussion below gives an overview of some important concepts involved in the preparation of the cash flow statement. Cash Flows from Operating Activities Operating activities generally involve providing services, and producing and delivering goods. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of profit or loss. This cash flow can be presented using either the direct or the indirect method. Using the direct method, the entity's net cash provided by (used in) operating activities is obtained by adding the individual operating cash inflows and then subtracting the individual operating cash outflows. The indirect method derives the net cash provided by (used in) operating activities by adjusting profit for income and expense items not resulting from cash transactions, The adjustment begins with profit followed by the addition of expenses and charges (e.g. depreciation) that did not entail cash payments. Then, increases in current assets and decreases in current liabilities involved in the determination of profit but which did not actually increase or decrease cash, are subtracted from profit. Finally, decreases in current assets and increases in current liabilities are added to profit to obtain net cash provided by (used in) operating activities. Profit Pr ‘Adjustments for: Non-Cash Expenses (e.g. Depreciation) xx Increases in Current Asset Accounts (wo) Decreases in Current Liabilit od) Decreases in Current Asset Accounts x Increases in Current Liability Accounts x Cash Flows from Operating Activities Po For example, increases in accounts receivable from sale of services or goods represented an increase in profit without the corresponding increase in cash—for itis. still a receivable. Since these revenues are already included in the computation of profit, the increase in accounts receivable should be deducted from the profit figure. To illustrate further, assume that salaries payable increased. Increases in salaries payable meant that the entity did not pay the full amount of salaries expense for the period. ‘The expense in the income statement, for cash flow purposes, is overstated by the amount of unpaid salaries. If expense is overstated, then profit is understated by the same amount; hence, the increase in current liability is added to profit. Per International Accounting Standards (IAS) No. 7, Cash Flow Statements, enterprises ‘are encouraged to report cash flows from operating activities using the direct method but the indirect method is acceptable. Only the direct method is illustrated here usingassumed amounts. The following are the major classes of operating cash flows using the direct method: Cash inflows receipts from sale of goods and performance of services receipts from royalties, fees, commissions and other revenues Cash Outflows * payments to suppliers of goods and services * payments to employees ‘payments for taxes % payments for interest expense payments for other operating expenses Cash Flows from Investing Activities 'nvesting activities include making and collecting loans; acquiring and disposing of investments in debt or equity securities; and obtaining and selling of property and. equipment and other productive assets. Cash inflows # receipts from sale of property and equipment receipts from sale of investments in debt or equity securities % receipts from collections on notes receivable Cash Outflows @ payments to acquire property and equipment ® payments to acquire debt or equity securities payments to make loans to others generally in the form of notes receivable ‘Cash Flows from Financing Activities Financing activities include obtaining resources from owners and creditors, Cash Inflows % receipts from investments by owners % receipts from issuance of notes payable Cash Outfiows ¢ payments to owners in the form of withdrawals ‘¢ payments to settle notes payableWarlito Blanche Company ‘Statement of Cash Flows For the Month Ended May 31, 2008 ‘Cash Flows from Operating Activities: Cash received from clients Payments to suppliers Payments to employees Payments for office rent Payments for insurance Payments for utilities ‘Net cash provided by (used in) operating activities, Cash Flows from inves Payments to acquire service vehicle (4,200,000) Payments to acquire office equipment (150,000) ‘Net cash provided by (used in) investing activities (4,350,000) ‘Cash Flows from Financing Activities: Cash received as investments by owner P 2,500,000 Cash received from borrowings 2,100,000 Payments for withdrawals by owner (240,000) Net cash provided by (used in) financing activities 4,860,000 Net increase (Decrease) in Cash and Cash Equivalents P 226,000 Cash and Cash Equivalents at the beginning of the period 125,000 ‘Cash and Cash Equivalents at the end of the period P 351,000 The use of internal controls over cash receipts and disbursements was already discussed in Basic Accounting Made Easy 2008 Edition by Win Ballada. The establishment and maintenance of a petty cash fund and the control of cash through a bank account were also illustrated lengthily,