Chapter 3: Partnership Operations

1.1 RULES FOR THE DISTRIBUTION OF PROFITS AND LOSSES

1.2 PRIMARY BASES OF DISTRIBUTION OF PROFITS AND LOSSES
1.3 SALARIES, INTEREST, BONUS

Learning outcomes of the Lesson

At the end of the unit, the students must have:
1. The students were able to correctly distribute profits/ losses using the primary bases. (PLO 4; PI 2)
2. The students were able to accurately allocate profits/losses with Salaries, Interest, and Bonus. (PLO 4; PI 2)

3.1 RULES FOR THE DISTRIBUTION OF PROFITS AND LOSSES

The profit or losses shall be distributed in conformity with the 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.

1. Profits
a. According to partner’s agreement
b. If there’s no agreement:
i. As to capitalist partners, according to capital contributions.
ii. As to industrial partner, share must be just and equitable under the
circumstances, provided, that the industrial partner shall receive such share
before the capital partners shall divide the profits.
2. Losses
a. According to partner’s agreement
b. If there is no agreement as to contribution of losses but there is an agreement as to
profits, the losses shall be distributed according to profit sharing ratio.
c. If there’s no agreement:
i. As to capitalist partners, according to capital contribution.
ii. As to Purely industrial partner, shall not be liable for any losses.

The ratio in which the profits and losses from partnership operations are distributed is recognized
as the profit and loss ratio. The partners may agree on any of the following scheme in distributing profits
or losses.
1. Based on partner’s capital contribution
a. Ratio of original capital investments
b. Ratio of capital balances at the beginning of the year
c. Ratio of capital balances at the end of the year
d. Ratio of average capital balances
2. Equally or in other agreed ratio
3. By allowing interest on partner’s capital and the balance in an agreed ratio.
4. By allowing salaries to partners and the balance in an agreed ratio.
5. By allowing bonus to the managing partner based on profit and the balance in an agreed
ratio.
6. By allowing salaries, interest on partners’ capital, bonus to the managing partner and the
balance in an agreed ratio (comb. 3-5).

Learning Module for Independent Learning 1

3.2 PRIMARY BASES OF DISTRIBUTION OF PROFITS AND LOSSES
ILLUSTRATION:
Ching invested P400,000 on Jan. 1 2020 and an additional P100,000 on April 1. Grant invested
P800,000 on Jan. 1 and withdrew P50,000 on July 1. The partnership had a profit of P300,000 for the
year ended Dec. 31, 2020, the first year of operations.

EQUALLY OR IN OTHER AGREED RATIO

 The partners agreed the share the profit or loss equally. Income Summary
300,000
Ching, Capital 150,000
Grant, Capital 150,000
To record the division of profits

 In case the partnership incurred a loss instead of profit worth

P200,000.
Ching, Capital 100,000
Grant, Capital 100,000
Income Summary 200,000
To record the division of losses

 Assume partners decided to have a P/L ratio of 60:40 in their profit of P300,000.
Income Summary 300,000
Ching, Capital 180,000
Grant, Capital 120,000
To record the division of profits

Computation:
Ching, Capital (60% x 300,000) 180,000
Grant, Capital (40% X 300,000) 120,000
300,000
BASED ON PARTNERS’ CAPITAL CONTRIBUTION

 Ratio of Original capital investment

Just a recap, the original investment of Ching and Grant is 400,000 and 800,000
respectively. Thus, based on this, the ratio will be 33.33% (400k/1,200k) and 66.67% (800k /
1,200k).
Income Summary 300,000
Ching, Capital 100,000
Grant, Capital 200,000
To record the division of profits

 Ratio of Capital Balances at the Beginning of the Year

Learning Module for Independent Learning 2

 In this case, the capital balances at the beginning of the year is also the original capital
investment since the partnership is only on its first year of operations. But on the
succeeding years of operations, the capital beginning will be change prospectively apart from
the original investment.
Income Summary 300,000
Ching, Capital 100,000
Grant, Capital 200,000
To record the division of profits

 Ratio of Capital Balances at the End of the Year

The Ending balances at the end of the year before the
distribution of profit. Thus,

Date Ching, Capital Grant, Capital Total

Jan. 1 400,000 800,000 1,200,000
Apr. 1 100,000 100,000
July 1 (50,000) (50,000)
Total 500,000 750,000 1,250,000

The ratio on this will be 40% for Ching (500k/1,250k) and 60% for Grant (750k/1,250k).
Income Summary 300,000
Ching, Capital 120,000
Grant, Capital 180,000
To record the division of profits

 Ratio on Average Capital Balances

Ching and Grang

Computation of the Average Capita Balances For the year
ended Dec. 31, 2020

Ching, Capital
Date Capital Accnt. Portion * of the year Ave. Capital
Balances unchanged Balances

Learning Module for Independent Learning 3

 Jan. 1 400,000 X 3/12 = P100,000
Apr. 1 500,000 X 9/12 = 375,000
= 475,000
Grant, Capital
Date Capital Accnt. Portion * of the year Ave. Capital
Balances unchanged Balances
Jan. 1 800,000 X 6/12 = P400,000
July 1 750,000 X 6/12 = 375,000
= 775,000

Total Average Capital Bal. = P 1,250,000

* The fractions for each partner should add up to 12/12 or 1. This conversion will help
minimize counting of errors as to the number of months the capital balance went unchanged. To
state the obvious, there are only 12 months in a year. For e.g.for partner Ching, the fraction will
total 12/12 (3/12 + 9/12) or in simple terms, 1.

The ratio on this would be 38% (475k/1,250k) and

62% (775k/1,250k) respectively. Thus, the entry would be,
Income Summary 300,000
Ching, Capital 114,000
Grant, Capital 186,000
To record the division of profits

 By Allowing Interest on Capital and Balance in a Agreed Ratio

To allow interest on partner’s capital account balances is almost similar to dividing part of
profits in the ratio of partner’s 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 rate 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.

To illustrate, Ching and Grant Partnership with a profit of 300,000 assumed an

agreement for a 15% interest on average capital account balances, with the balance to be divided
equally.

Ching Grant Total

15% interest on Ave. Capital Ching:
475k x 15% Grant: 775k x 15% 71,250
Subtotal 116,250
Balance to be divided Equally 187,500
 (300k–187,500=P112,500 x 50%) 56,250 56,250 112,500
Share of Partners in profits 127,500 172,500 300,000

The journal entry would be:

Income Summary 300,000
Ching, Capital 127,500
Grant, Capital 172,500
To record the division of profits

 By Allowing Salaries to Partners and the Balance in an Agreed Ratio

To acknowledge the harder working or more suitable 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, salary allowances
will be provided even when operations resulted losses.

To illustrate, assume that the agreement provided for an annual salary of P100,000 to
Ching and P60,000 to Grant, and the balance to be divided equally.
Ching Grant Total
Salary Allowances 100,000 60,000 160,000
Balance to be divided Equally
(300k–160k = P140,000 x 50%) 70,000 70,000 140,000
Share of Partners in profits 170,000 130,000 300,000

The journal entry would be:

Income Summary 300,000
Ching, Capital 170,000
Grant, Capital 130,000
To record the division of profits

3.3 SALARIES, INTEREST, BONUS

Salaries to partners and interest on partners’ capital are

not expenses of the partnership. Therefore, these items do not
enter into the matching of expenses with revenues and the
determination of net income or net loss. For a partnership, as for
other entities, salaries expense pertains to the cost of services
performed by employees. Likewise, interest expense relates to the
cost of borrowing from creditors. But partners, as owners, are not
considered either employees or creditors. 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.

 By Allowing Bonus to the Salaries of 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 to
the managing partner when the results of operations are favorable. The bonus is computed
based on agreement whether before or after bonus. To illustrate:

Assume the partnership agreement provided for a bonus of 25% of profit before bonus.
Ching Grant Total
Bonus (25% of P300,000) 75,000 75,000
Balance to be divided Equally
(300k – 75k = P225,000 x 50%) 112,500 112,500 225,000
Share of Partners in profits 187,500 112,500 300,000

The journal entry would be:

Income Summary 300,000
Ching, Capital 187,500
Grant, Capital 112,500
To record the division of profits

Assume the partnership agreement provided for a bonus of 25% of profit after bonus.
Here the P300,000 profit still includes the bonus. The difference between this profit and bonus
shall be the basis for the 25% bonus rate. Hence, profit after bonus represents 100% while the
profit of P300,000 before bonus represents 125%.

Ching Grant Total

Bonus ** 60,000 60,000
Balance to be divided Equally
(300k – 60k = P240,000 x 50%) 120,000 120,000 240,000
Share of Partners in profits 180,000 120,000 300,000

** Profit before Bonus 300,000 125%

Profit after Bonus 240,000 100%
Bonus 60,000 25%
 The journal entry would be:
Income Summary 300,000
Ching, Capital 180,000
Grant, Capital 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

Assume that the profit for the year is P400,000 and the partnership agreement for he
Ching and Grant Partnership provided the following:
1. Bonus to Ching of 25% of profit after salaries and interest but before bonus;
2. Annual salaries of P100,000 to Ching and P60,000 to Grant;
3. Interest on average capital balances of P71,250 and P116,250 to Ching and Grant,
respectively;
4. Balance to be divided in a ratio of 40:60.

Ching Grant Total

Salary Allowances 100,000 60,000 160,000
Interest on Ave. Cap. Bal. Bonus 71,250 116,250 187,500
(25% of Balance)
Profit P400,000
Salary (160,000)
Interest (187,500)
Balance P 52,500 13,125 13,125
Balance to be divided 40:60
Balance P 52,500
Bonus ( 13,125)
P 39,375 15,750 23,625 39,375
Share of Partners in profits 200,125 199,875 400,000

The journal entry would be:

Income Summary 400,000
Ching, Capital 200,125
Grant, Capital 199,875
To record the division of profits

Assume instead that the bonus to Ching is 25% of profit after salaries, interest and after
bonus. The computation of the bonus will be:**
Profit 400,000
Less: Salaries 160,000
Interest 187,500 347,500
Profit after Sal. & Int. but before bonus 52,500 125%
Profit after Sal. & Int. &after bonus 42,000 100%
Bonus 10,500 25%
 Ching Grant Total
Salary Allowances 100,000 60,000 160,000
Interest on Ave. Cap. Bal. 71,250 116,250 187,500
Bonus ** 10,500 10,500
Balance to be divided 40:60
Profit P400,000
Salary (160,000)
Interest (187,500)
Bonus ( 10,500)
Balance P 39,375 16,800 25,200 42,000
Share of Partners in profits 198,550 201,450 400,000

The journal entry would be:

Income Summary 400,000
Ching, Capital 198,550
Grant, Capital 201,450
To record the division of profits

Self-test questions

ACTIVITY NO. 1
Rules for Distribution of Profit or Losses

Luka and Care form a partnership, investing P40,000 and P70,000, respectively.
Determine their shares of net income or net loss for each of the following situations.
a. Net loss is P44,000, and the partners have no written partnership agreement.
b. Net income is P66,000 and the partnership agreement states that the partners
shares profits and losses on the basis of their capital contributions.
c. Net loss is P77,000, and the partnership agreement states that the partners
share profits on the basis of their capital contributions.
d. Net income is P125,000. The first P60,000 is shared on the basis of partner
capital contributions. The next P 45,000 is based on partner service, with Luka
receiving 30% and Care receiving 70%. The remainder is shared equally.

ACTIVITY NO. 2
Distribution of Profits or Losses based on partner’s agreement

Tito, Tara, and Tina are partners in T-Account Company, with average capital balances
for the year of 300,000, 400,000 and 200,000, respectively. They share remaining profits
and losses in a 2:5:3 respectively, after each receives a P150,000 salary and 10%
interest on his average capital balances.

Required:
Prepare the journal entries to close the income summary, assuming a:
a. Profit of P740,000
b. Profit of P140,000
c. Loss of P60,000

ACTIVITY NO. 3
Distribution of Profits or Losses based on partner’s agreement
Pat, Paula and Ian are partners who shares profits and losses 40:40:20, respectively,
after Paula, who manages the partnership, receives a bonus of 10% of income after
deducting the bonus. Partnership income for the year is P506,000.

Required:
Prepare a schedule to allocate partnership income to Pat, Paula and Ian.

ACTIVITY NO. 4
Profit Distribution Schedule

The partnership contract of Eric, Will and Pam provided for the distribution of profit or loss
in the following manner:
1. Bonus of 25% of profit before the bonus to Eric.
2. Interest at 15% on average capital balances to each partner
3. Residual profit or losses are divided equally.

Profit of Eric, Will and Pam for 2020 was P900,000, and the average capital account
balances for the year were Eric, P1,000,000; Will, P2,000,000; and Pam, P3,000,000.

Required:
Prepare the profit distribution schedule.