MODULE 2: PARTNERSHIP OPERATIONS AND FINANCIAL REPORTING

NATURE OF PARTNERSHIP OPERATION

Accounting for partnership operations is essentially the same as accounting for operations of a
sole proprietorship. Sale of merchandise on account is debited to Accounts Receivable and
credited to Sales. Collection of accounts is debited to Cash and credited to Accounts Receivable.
Purchase of merchandise on account is recorded by a debit to Purchases and credit to Accounts
Payable. Payment of accounts is debited to Accounts payable and credited to cash. Payment of
expenses is debited to Expenses and credited to Cash.

At the end of the accounting period, adjustments are made for merchandise
inventory, accruals, prepayments, provision for doubtful accounts, and provision for
depreciation. Net income is determined in the usual manner, that is, by matching
periodic revenues and expenses.

However, special problems are encountered in accounting for partnership operations. These
problems include:

1. Closing entries of a partnership

2. Distribution of profits and losses
3. Preparation of a work sheet
4. Preparation of financial statements
a. Statement of income/statement of comprehensive income
b. Statement of financial position
c. Statement of changes in partners’ equity

CLOSING ENTRIES OF A PARTNERSHIP

The procedures for the preparation of closing entries for a partnership are
similar to that of a sole proprietorship. First, all revenue and nominal accounts
with credit balances (such as Purchases Discounts) are debited and Income
Summary is credited. Second, Income Summary is debited and all expense and
other nominal accounts with debit balances (such as Sales Returns and Allowances)
are credited. Third, the balance of the Income Summary account, which represents
income or loss of the partnership, is transferred either to the drawing accounts or
capital accounts of the partners. Finally, the balance of the drawing account of each
partner is transferred to his capital account.

The balance of the Income Summary account is transferred to the drawing accounts of the
partners if the partners' intention is to keep the capital account intact for investments and
permanent withdrawals of capital. On the other the balance of the Income Summary account is
transferred to the capital accounts of the partners if the partners' intention is to make net income
or loss directly a part of permanent capital. It should be noted, however, that either treatment will
result to the same net effect on partners' ending capital balances. All illustrations in this module
pertaining to distribution of net income or net loss are made to the capital accounts with the

1| P a g e
assumption that partners intend to make their respective share on the net income or net loss as
a direct part of their permanent capital.

A credit balance in the Income Summary account represents net income and its balance is closed
as follows:

Income Summary xxx

A, Capital xxx
B, Capital xxx

A debit balance in the Income Summary account represents net loss and its balance is closed as
follows:

A, Capital xxx
B, Capital xxx
Income Summary xxx

DISTRIBUTION OF PROFITS AND LOSSES

In the distribution of partnership profits and losses, the following factors should
be considered:

1. Services rendered by the partners to the partnership.

2. Amount of capital contributed by the partners to the business.
3. Entrepreneurial ability or managerial skill of the partners.

The distribution or division of profits and losses may be expressed in several ways as follows:
1. By percentage
2. By fraction
3. By decimal
4. By ratio

Illustration:

Black and White are partners sharing profits and losses based on their capital contributions of
P40,000 and P60,000 respectively. Their profit and loss sharing can be expressed as follows:

1. By percentage Black 40% (40/100)

White 60% (60/100)
2. By fraction Black 4/10 (40,000/100,000)
White 6/10 (60,000/100,000)
3. By decimal Black 0.40 (40,000/100,000)
White 0.60 (60,000/100,000)
4. By ratio Black and White 4:6 or 2:3, respectively

2| P a g e
RULES FOR DIVIDING PROFITS AND LOSSES

The following is the list of rules in the division of profits and losses of the
partnership based on the provisions of the New Civil Code:

1. As to Capitalist Partners
a. Division of profits
1. In accordance with agreement
2. In the absence of an agreement, division of profits is in accordance with their capital
contributions

b. Division of losses
1. In accordance with agreement
2. If only the division of profits is agreed upon, then the division of losses will be the
same as the agreement on division of profits
3. In the absence of an agreement, division of losses is in accordance with capital
contribution

2. As to Industrial Partners
a. Division of Profits
1. In accordance with agreement
2. In the absence of an agreement, the industrial partner shall receive a just and
equitable share of the profits and the. capitalist partners in accordance with their
capital contribution.

b. Division of Losses
1. In accordance with agreement
2. In the absence of an agreement, the capitalist-industrial partner in his character as an
industrial partner shall have no share in the losses, but in his character as a capitalist
partner will share in proportion to his capital contribution.

Profits and losses in general shall be divided in accordance with the agreement among the
partners. In the absence of an agreement, the partners shall share in the profits in proportion to
their capital after satisfying the share of the industrial partner on such income.

METHODS OF DISTRBUTING PROFITS BASED ON PARTNERS' AGREEMENT

1. Equally - it is simple to apply but does not give due recognition on the disparity of capital
contribution nor does it recognize the time and effort that a partner may devote in running
the firms business operations.

2. Arbitrary ratio (Percentage, Decimal, Fraction, Ratio) - it is simple to apply but does not
give recognition on the disparity of capital contributions nor does it recognize the time and
effort that a partner may devote in running the firm's business operations.

3| P a g e
3. According to capital ratio (Original, Beginning, Ending, Average) - this method
recognizes the differences in the capital contributions but does not take into account the
time and effort that a partner may devote in running the firm's business.

4. Interest on capital and the balance on agreed ratio - this method recognizes the
differences in the capital contributions but does not take into account the time and effort that
a partner may devote in running the firm’s business.

Interest is allowed to partners for the use of invested capital. Interest as agreed by partners
shall be allowed in proportion to the period such capital was actually used, whether the
income is sufficient or insufficient or there is net loss, unless otherwise agreed upon by the
partners.

5. Salary allowances to partners and the balance on agreed ratio - this method recognizes
the time and effort that a partner may devote in running the firm's business but does not take
into consideration the differences in capital contributions.

Salaries are allowed to partners as compensation for their time devoted in the business.
Salaries as agreed by partners shall be allowed in proportion to the period the partners
actually rendered services to the firm. Such salaries shall be provided, whether the income
is sufficient or not or there is a net loss, unless otherwise agreed upon by the partners.

6. Bonus to managing partner and the balance on agreed ratio - this method allows bonus
to the managing partner as an incentive which is usually based on net income. Bonus,
therefore, is allowed only when there is sufficient net income. It may be computed using any
one of the following as the basis:
a. Bonus is based on net income before deducting bonus and income tax.
b. Bonus is based on net income after deducting bonus but before deducting income tax.
c. Bonus is based on net income before deducting bonus but after deducting income tax.
d. Bonus is based on net income after deducting both bonus and income tax.

7. Interest on capital, salaries to partners, bonus to managing partner, and the

balance on agreed ratio.

Illustrative Problem A: The following data are available in the books of Alice and Louella
Partnership for the year 2001:

Alice, Capital
Dr Cr
May 1 10,000 Jan. 1 balance 250,000
Apr 1 25,000
Oct 1 50000

Alice, Drawing
Dr Cr
Jan 1 – Dec 31 30,000

4| P a g e
 Louella, Capital
Dr Cr
June 1 15,000 Jan. 1 balance 150,000
Dec 1 5,000 Sept 1 50,000

Louella, Drawing
Dr Cr
Jan 1 – Dec 31 22,500

Income Summary
Dr Cr
Dec 31 60,000

Twelve cases will be illustrated using the given data. Cases 1-10 will show sufficient income,
Case 11 will show insufficient income, and Case 12 shows a net loss.

Case 1: Net income is divided equally

Income Summary 60,000

Alice, Capital 30,000
Louella, Capital 30,000
(P60,000 ÷ 2 = P30,000)

Case 2: Net income is divided 3/4 and 1/4 to Alice and Louella

Income Summary 60,000

Alice, Capital 45,000
Louella, Capital 15,000
(P60,000 x 3/4 = P45,000)
(P60,000 x ¼ = P15,000)

Case 3: Net income is divided in the ratio of 1:4 to Alice and Louella.

Income Summary 60,000

Alice, Capital 12,000
Louella, Capital 48,000
(P60,000 x 1/5 = P12,000)
(P60,000 x 4/5 = P48,000)

5| P a g e
Case 4: Net income is allocated on the beginning capital ratio

Income Summary 60,000

Alice, Capital 37,500
Louella, Capital 22,500
(250,000 ÷ 400,000 x 60,000)
(150,000 ÷ 400,000 x 60,000)

Case 5: Net income is allocated on the ending capital ratio

Income Summary 60,000

Alice, Capital 38,182
Louella, Capital 21,818
(315,000 ÷ 495,000 x 60,000) = 38,182
(180,000 ÷ 495,000 x 60,000) = 21,818

Alice Louella
Beg. Capital 250,000 150,000
Additional Investment 75,000 50,000
Drawing (10,000) (20,000)
Ending Capital 315,000 180,000

It must be noted that withdrawals deducted for purposes of determining ending

capital balances are the debit entries in the capital accounts of each of the partners.
These debit entries represent permanent withdrawals or decreases on capital. The
credit entries represent initial and/or additional investments.

On the other hand, the debits to the drawing account represent temporary
withdrawals or decreases in capital caused by the share in net loss (but may be debited
directly to the capital account) or withdrawal of assets in anticipation of profits. The
credit entries represent increases in capital (may be credited directly to the capital
account) caused by the share in net income. The entries in the drawing accounts are
not considered in computing ending capital for the purpose of establishing the ratio.

Case 6: Net income is allocated on the simple average capital

(Beg + End) / 2

Income Summary 60,000

Alice, Capital 37,877
Louella, Capital 22,123
Alice (250,000 + 315,000) / 2 = 282,500/447,500 x 60,000 = 37,877
Louella (150,000 + 180,000) / 2 = 165,000/447,500 x 60,000 = 22,123

6| P a g e
Case 7: Net income is allocated on the average capital ratio

Income Summary 60,000

Alice, Capital 38,129
Louella, Capital 21,871
Alice (274,583/432,083) x P60,000 = P38,129
Louella (157,500/432,083 x P60,000 = 21,871

Average capital ratio is a method of dividing profits based on the amount of capital invested and
the time during which such capital is actually used in the business.

The following steps are to be followed in determining the average capital of each partner, thus
arriving at the average capital ratio:

1. Multiply beginning capital by the number of months that it remained unchanged.

2. Determine each new capital balance in chronological order and multiply by the number of
months it remained unchanged.
3. Add the products which represent peso months and divide the total by twelve (12) to obtain
the average monthly capital.

By following the steps given, the average capital for each of the partners can be calculated as
follows:

Alice, Capital
Capital # of Months Peso Average
Period
Balance unchanged Months Capital
Jan 1 Investment 250,000 3 750,000
Apr 1 Invest. 25k 275,000 1 275,000
May 1 Drawing 10k 265,000 5 1,325,000
Oct 1 Invest. 50k 315,000 3 945,000
12 3,295,000 274,583

Louella, Capital
Capital # of Months Peso Average
Period
Balance Unchanged Months Capital
Jan 1 Investment 150,000 5 750,000
June 1 Drawing 15k 135,000 3 405,000
Sept 1 Invest. 50k 185,000 3 555,000
Dec 1 Drawing 5k 180,000 1 180,000
12 1,890,000 157,500

274,583 + 157,500 = 432,083

7| P a g e
Case 8: Each partner is allowed 10% interest on ending capital and the remaining income
is divided 60%, 40%

Income Summary 60,000

Alice, Capital 37,800
Louella, Capital 22,200

The distribution of profit may be recorded separately as follows:

Income Summary 49,500

Alice, Capital 31,500
Louella, Capital 18,000

Income Summary 10,500

Alice, Capital 6,300
Louella, Capital 4,200
Remaining income divided 60%, 40%.

Division of net income:

Alice Louella Total

Interest on ending capital
315,000 x 10% 31,500
180,000 x 10% 18,000 49,500
Remainder - 60%; 40%
(60,000-49,500) = 10,500 x 60% 6,300
(60,000-49,500) = 10,500 x 40% 4,200 10,500
Total 37,800 22,200 60,000

Case 9: Louella is allowed salaries of P50,000 and the remaining income divided in the ratio
of 1:4

Income Summary 60,000

Alice, Capital 2,000
Louella, Capital 58,000

Division of net income:

Alice Louella Total

Salaries 50,000 50,000
Remainder - 1:4
(60,000-50,000) =10,000 x 1/5 2,000
(60,000-50,000) = 10,000 x 4/5 8,000 10,000
Total 2,000 58,000 60,000

8| P a g e
Case 10: Louella, the managing partner, is allowed a bonus of 20% of income BEFORE
bonus and income tax and the remainder is divided in the ratio of beginning capital.

Using the current income tax rate of 32%, the partnership income before income tax is P88,235,
that is, net income of P60,000 divided by 68% (68% is computed as 100% less tax rate of 32%).

Income Summary 60,000

Alice, Capital 26,471
Louella, Capital 33,529

Division of net income:

Alice Louella Total

Bonus - 88,235 x 20% 17,647 17,647
Remainder:
42,353 x 250/400 26,471
42,353 x 150/400 15,882 42,353
Total 26,471 33,529 60,000

Other assumptions on the computation of bonus shall be illustrated later in the chapter.

Case 11: The partners are allowed P500 and P1,000 weekly salaries, respectively, 10%
interest on average capital, and the remainder is divided in the ratio of 2:3.

Income Summary 60,000

Alice, Capital 28,975
Louella, Capital 31,025

Division of net income:

Alice Louella Total

Salaries to partners
500 x 52 weeks 26,000
1,000 x 52 weels 52,000 78,000
Interest on average capital
274,583 x 10% 27,458
157,500 x 10% 15,750 43,208
Remainder
(61,208) x 2/5 (24,483)
(61,208) x 3/5 (36,725) (61,208)
Total 28,975 31,025 60,000

The sum of the salary allowance to partners and interest allowed on the average capital of the
partners exceeds the net income of P60,000 resulting in a negative remainder (loss). Such loss is
distributed as provided in the profit and loss sharing agreement.

9| P a g e
Case 12: Assume the same agreement as in Case 11 except that instead of a net income,
the partnership has incurred a net loss of P10,000. The allowance for salaries and interest will
still be provided, thereby resulting in a total loss to be divided as agreed.

Louella, Capital 10,975

Alice, Capital 975
Income Summary 10,000

Division of net income (loss):

Alice Louella Total

Salaries to partners
P500 x 52 weeks 26,000
P1,000 x 52 weeks 52,000 78,000
Interest on average capital:
P274,583 x 10% 27,458
P157,500 x 10% 15,750 43,208
Remainder:
(131,208) x 2/5 ( 52,483)
(131,208) x 3/5 ( 78,725) (131,208)
Total 975 (10,975) (10,000)

The allocation of partnership profit follows the order of the profit sharing agreement in allocating
the bonus, the salary allowances, the interests and the remainder to individual partners.

The bonus is computed on the basis of the partnership profit as the concept of “partnership profit”
is generally understood in accounting practice. Partners may, however, intend for salary and
interest allowances to be deducted in determining the base for computing the bonus. In such
case, no bonus is allowed if there is insufficient profit after distribution of salaries and interests.

Illustrations on the computation of bonus using other assumptions.

The same data in Illustrative Problem A shall be used. Bonus rate is 20%.

1. Bonus is based on income AFTER deducting bonus but BEFORE deducting income tax.

B = 0.20 x ((60,000/68%) – B)
B = 0.20 x (88,235 – B)
B = 17,647 – 0.2B
B + 0.2B = 17,647
1.2B = 17,647
B = 17,647 / 1.2
B = 14,706

10| P a g e
2. Bonus is based on income BEFORE deducting bonus but AFTER deducting income tax

B = 0.20 (88,235 - T)
Where: =
T = 0.32 x 88,235

Substituting for T in the first equation and solving for B:

T = 0.32 x 88,235
T = 28,235

B = 0.20 (88,235 – 28,235)

B = 0.20 x 60,000
B = 12,000

Key Points. The bonus was not deducted from the income subject to income tax. The bonus
being computed is not an expense but a distribution of net income after income tax.

3. Bonus is based on income after deducting both bonus and income tax.

B = 0.20 (88,235 – B – T)
Where:
T = 0.32 x 88,235
T = 28,235

Substituting for T in the first equation and solving for B

B = 0.20 (88,235 – B – 28,235)

B = 0.20 (60,000 – B)
B = 12,000 – 0.2B
B + 0.2B = 12,000
1.2B = 12,000
B = 12,000 / 1.2
B = 10,000

Key Points. In the preceding examples, bonus is treated as a distribution of partnership income,
and therefore such bonus is not deductible as an expense in determining the amount of taxable
income. The same is true for salaries and interest allowed on capital. However, when such
salaries, interests, and bonuses are treated as expenses rather than as distribution of income,
such are deductible as expenses in determining the amount of taxable income.

Illustrations on the computation of bonus when it is treated as an expense rather than as a

distribution of income are presented on the next page. The data used for the partnership of Alice
and Louella will also be used. Bonus rate is also 20%.

11| P a g e
1. Bonus is based on income BEFORE deducting bonus but AFTER deducting income tax.

B = 0.20 (88,235 -T)

Where: =
T = 0.32 (88,235 - B)
Therefore:
B = 0.20 ((88,235 – (0.32 (88,235 – B))
B = 0.20 (88,235 – 28,235 + 0.32B)
B = 0.20 (60,000 + 0.32B)
B = 12,000 + 0.064B
B – 0.064B = 12,000
0.936B = 12,000
B = 12,820.50 or 12,821

2. Bonus is based on income AFTER deducting both bonus and income tax

B = 0.20 (88,235 – B – T)
Where: =
T = 0.32 (88,235 – B)

B = 0.20 (88,235 – B - (0.32 (88,235 – B))

B = 0.20 (88,235 – B – 28,235 + 0.32B)
B = 0.20 (60,000 – 0.68B)
B = 12,000 – 0.136B
B + 0.136B = 12,000
1.136B = 12,000
B = 12,000 / 1.136
B = 10,563

12| P a g e