College of Accountancy

PARTNERSHIP OPERATION
Contents:
3.1. Rules for the Distribution of Profits and Losses
3.2. Basis for Distribution of Profits and Losses
3.3. Correction of Errors
3.4. Partnership’s Income Statement

Lesson 3.1 Rules for the Distribution of Profits and losses

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 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
a. The losses will be divided according to the partners’ agreement.
b. If there is no agreement as to the distribution of losses but there is an agreement as to
profits, the losses shall be divided according to the profit sharing ratio.
c. 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 real sense, he has
already contributed his share in the loss.

Lesson 3.2 Basis for Distribution of Profit and Losses

The partners may agree on any of the following scheme in distributing profits and losses:
1. Equally or in other agreed ratio
2. Based on partners’ capital contributions:
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
3. By allowing interest on partners’ capital and balance in an agreed ratio.
4. By allowing salaries to partner’s capital 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.

Salaries (S) – normally, an industrial partner receives salary in addition to his share in
the partnership’s profits as compensation for his services to the partnership.

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Bonuses (B) – the managing partner may be entitled to a bonus for excellent management
performance. Unlike for salaries, a partner is entitled to a bonus only if the partnership
earns profit. The partner is not entitled to any bonus if the partnership incurs loss.
Bonus can be computed in various ways such as:
 Based on net income (NI)
Formula: B = B% x NI
This is based on net income before deducting salaries, interest and bonus.
 Based on net income after salaries, interest and bonus
Formula: B = B% x (NI – S – I – B)
 Based on net income after salaries and interest
Formula: B = B% x (NI – S – I)
 Based on net income after salaries and bonus
Formula: B = B% x (NI – S – B)
 Based on net income after interest and bonus
Formula: B = B% x (NI – I – B)
 Based on net income after salaries
Formula: B = B% x (NI – S)
 Based on net income after interest
Formula: B = B% x (NI – I)
 Based on net income after bonus
Formula: B = B% x (NI – B)

Interest on capital contributions (I) – the partnership agreement may stipulate that
capitalist partners are entitled to an annual interest on their capital contributions.

Note: Salaries, Interest and Bonuses are only tools in dividing the profits and should
never be treated as a company expense.

Illustration:
The following data are given in the books of Hobbs and Shaw Partnership for the year 20x1.
Hobbs, Capital Hobbs, Drawing
Jan. 1 400,000 Jan. – Dec.
April 1 100,000 60,000

Shaw, Capital Shaw, Drawing

July 1 Jan. 1 800,000 Jan. – Dec.
50,000 60,000

Income Summary
Dec. 31
300,000

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.

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Case 1: Equally or in Agreed Ratio

a. Equally
Income Summary 300,000
Hobbs, Capital 150,000
Shaw, Capital 150,000
To record the division of
profits
b. Assume instead that the partnership had a loss of 100,000
Hobbs, Capital 50,000
Shaw, Capital 50,000
Income Summary 100,000
To record the division of losses
c. Agreed Ratio (60:40)
Income Summary 300,000 Computation:
Hobbs, Capital 180,000 Hobbs: 60% x P300,000 = P180,000
Shaw, Capital 120,000 Shaw: 40% x P300,000 = P120,000
To record the division
of profits
Case 2: Based on Partner’s Capital Contributions
a. Ratio of Original Capital
Income Summary 300,000 Computation:
Hobbs, Capital 100,000 Hobbs: 400,000/1,200,000 x P300,000 =
Shaw, Capital 200,000 P100,000
To record the division Shaw: 800,000/1,200,000 x P300,000 =
of profits P200,000

b. Ratio of Capital at the Beginning of the Year

Income Summary 300,000 Computation:
Hobbs, Capital 100,000 Hobbs: 400,000/1,200,000 x P300,000 =
Shaw, Capital 200,000 P100,000
To record the division Shaw: 800,000/1,200,000 x P300,000 =
of profits P200,000
c. Ratio of Capital Balances at the End of the Year
Income Summary 300,000 Computation:
Hobbs, Capital 100,000 Hobbs: 500,000/1,250,000 x P300,000 =
Shaw, Capital 200,000 P120,000
To record the division Shaw: 750,000/1,250,000 x P300,000 =
of profits P180,000
d. Ratio of Average Capital Balances
Income Summary 300,000 Computation:
Hobbs, Capital 114,000 Hobbs: 475,000/1,250,000 x P300,000 =
Shaw, Capital 186,000 P114,000
To record the division Shaw: 775,000/1,250,000 x P300,000 =
of profits P186,000

Computation of Average Capital Balances

For the Year Ended Dec. 31, 20x1
Hobbs, Capital
Date Capital Portion of the Year Average Capital
Account Unchanged Balances
Balances
Jan. 1 P400,000 x 3/12 = P100,000
April 1 500,000 x 9/12 = 375,000

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Average Capital P475,000

Shaw, Capital
Jan. 1 P800,000 x 6/12 = P400,00
July 1 750,000 x 6/12 = 375,000
Average Capital P775,000
Total Average P1,250,000
Capital

The agreement should 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 balances. On
the contrary, drawings in excess of the allowable amount are considered permanent reductions in
capital; hence, the excess withdrawals affect the computation of the average capital balances.

Case 3: By Allowing Salaries, Interest on Capital, and 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 the Hobbs and
Shaw Partnership provided the following:
1. Bonus to Hobbs of 25% of profit after salaries and interest but before bonus;
2. Annual salaries of P100,000 to Hobbs and P60,000 to Shaw;
3. 15% Interest on average capital account balances;
4. Balances to be divided in a ratio of 40:60.
Hobbs Shaw Total
Salary Allowances P100,000 P60,000 P160,000
15% Interest on Average Capital:
Hobbs: P475,000 x 15% 71,250
Shaw: P775,000 x 15% 116,250
Subtotal 187,500
Bonus [25% (P400,000 – P160,000 – 13,125 13,125
P187,500)]
Balance to be divided in the Ratio of 40:60
(P400,000 - P160,000 - P187,500 – P13,125
=P39,375): 15,750
Hobbs: P39,375 x 40% 23,625
Shaw: P39,375 x 60% 39,375
Share in the Partners in Profits P200,125 P199,875 P400,000

The journal entry to close the income summary ledger account on December 31, 2019 follows:
Income Summary 400,000
Hobbs, Capital 200,125
Shaw, Capital 199,875
To record the division
of profits

Lesson 3.3 Correction of Errors

Errors are omissions from and other misstatements of the entity’s financial statements.
Errors may occur as a result of mathematical mistakes, mistakes in applying accounting policies,
misinterpretation of facts or oversights.
a. Current Period Errors

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Errors in the current period discovered in the current period before closing the books.

Accounting Treatment:
Should be reported by adjusting the income summary and affected assets and liabilities
before closing to partners’ capital.
b. Prior Period 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.
Accounting Treatment:
 Should be reported by adjusting the opening balances of partners’ capital and affected
assets and liabilities.
 The correction of prior period error is excluded from profit or loss for the period in
which the error is discovered.
 If an error resulted in an understatement of profit in previous period, a correcting
entry would be needed to increase Partners’ capital accounts.
 If an error overstated profit in prior periods, then Partners’ capital accounts would
have to be decreased.
 The effect of the error correction will be divided based on the applicable profit or loss
ratio during the year the error is related.
Illustration:
Andrew and Boy created a partnership to own and operate a health-food store. The
partnership agreement provided that Andrew receive a salary of P10,000 and Boy a salary of
P5,000 to recognize their relative time spent in operating the store. Remaining profits and losses
were divided 60:40 to Andrew and Boy. Income for 20x1, the first year of operations, of P13,000
was allocated P8,800 to Andrew and P4,200 to Boy.
On January 1, 20x2, the partnership agreement was changed to reflect the fact that Boy
could no longer devote time to the store’s operations. The new agreement allows Andrew a
salary of P18,000, and the remaining profits and losses are divided equally. In 20x2 an error was
discovered such that the 20x1 reported income was understated by P4,000. The partnership
income of P25,000 for 20x2 included the P4,000 related to year 20x1.
Analysis:
 The distributed income in 20x1 is understated by P4,000. The partners received lesser
that what they should have received.
 The income related to 20x2 is P21,000 (P25,000 – P4,000)
 20x1 profit distribution is: 60:40 after providing P10,000 and P5,000 salary to Andrew
and Boy respectively.
 20x2 profit distribution is: 50:50 after providing P18,000 salary to Andrew.

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20x1 Division of Profits

Andrew Boy Total
Salary P10,000 P5,000 P15,000
Balance (60:40) (1,200) (800) (2,000)
Allocation of NI P8,000 P4,200 P13,000

Should be 20x1 Division of Profits

Andrew Boy Total
Salary P10,000 P5,000 P15,000
Balance (60:40) 1,200 800 2,000
Should be Allocation of NI P11,200 P5,800 P17,000 (13k + 4k)
Allocated NI (8,000) (4,200)
Additional Distribution to P2,400 P1,600
partners

Or simply divide using the ratio 60:40 = Andrew P2,400 (P4,000 x 60%); Boy P1,600
(P4,000 x 40%)
Note: The division basis used for the effect of prior period errors is the division basis
applicable to the year when the error is related.
20x2 Division of Profits
Andrew Boy Total
Salary P18,000 P-0- P18,000
Balance (60:40) 1,500 1,500 3,000
Allocation of NI P19,500 P1,500 P21,000

Total allocation of the P25,000

Andrew Boy Total
Allocation of NI P19,500 P1,500 P21,000
Allocated NI 2,400 1,600 4,000
P21,900 P3,100 P25,000

Journal Entries:
Various asset/liability accounts 4,000
Income Summary 21,000
Andrew, Capital 21,900
Boy, Capital 3,100
To record the division of profits
for 20x2 and the adjustment for
prior period errors.

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Lesson 3.4 Partnership’s Income Statement

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.
Illustration:
ABC PARTNERSHIP
Income Statement
For the Period Ended December 31, 20x1

Revenue P100,000
Less: Expenses 50,000
Net Profit P50,000

Division of Profit (40:30:30)

Partner A P20,000
Partner B 15,000
Partner C 15,000
Total P50,000

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