PARTNERSHIP OPERATIONS

CHAPTER 18
Introduction

The operations of a partnership are similar in most respects to those of other forms of
organizations operating in the same line of business. At the end of each fiscal year, when
revenues and expenses are closed out, some assignments must be made of the resulting
income figure because a partnership will have two or more capital accounts rather than a
single retained earnings balance. This allocation to the capital accounts is based on the
agreement established by the partners preferably as a part of the Articles of Partnership.

A wide range of profit allocation is found in the business world. Some partnerships have
straightforward distribution plans while others have extremely complex ones. It is the
accountant’s responsibility to distribute the profit or loss according to the partnership
agreement regardless of how simple or complex that agreement is. Profit distributions are
similar to dividends for a corporation.
Accounting for Partnership Operations: Methods to Allocate Net Income or Loss

In measuring partnership profit for a period, expenses should be scrutinized to make sure that partners’
personal expenses are excluded from the partnership’s business expenses. If personal expenses of a partner
are paid with partnership assets, the payment is charged to the drawing or capital account of that partner.
Drawings are closed to the capital accounts of the partners rather to an income summary account.

Practically all partnerships have a profit or loss allocation agreement. It would be rare to find a partnership
that did not spell out the divisions of profits or losses in details. The agreement must be followed precisely, and
if it is unclear, the accountant should make sure that all partners agree to the profit or loss distribution. Partners
should select a formula that is sensible, practical, and equitable. The formula used to divide profits and losses
is determined through negotiations among the partners. Whether it is fair or not, it does not concern the
accountant.

It is necessary that the benefit the partners expect to obtain from the combination of their respective
contribution should be common to all the partners, because if such were not the case, there would be no
partnership
Now the question that arises is: “How will the partners divide the profits or losses resulting from the operation of the
partnership?”

The Partnership Law provides that if the profit has been agreed upon, the share of each partner in the losses shall be in
the same proportion with the net income allocation. It also provides that in the absence of agreement, the share of each
partner in the profits and losses shall be in proportion to what they have contributed (based on capital contribution), but
the industrial partner shall receive such share as may be just and equitable under the circumstances.

However, the law is not clear as to what capital balances shall be applied, whether the capital balances refers to original
capital, beginning or end of each period or the average capital during the period. In as much as the law does not clearly
specify the capital balance, it is therefore, presumed to be the original capital, in the absence of such original capital it
should be the beginning capital.

The reason behind the usage of original capital (in his absence, the beginning capital) is that, if at the time of formation
there is no agreement, the law should apply and the only available capital balance is the original capital. Even though usage
of original capital seems to be unreasonable because of inequity, logic dictates that profit and loss should be established at
the time of formation due to some of the following reasons:
1. Subsequent adjustments in assets and liabilities;
2. Admission of a new partner;
3. Retirement or withdrawal of a partner; and
4. Liquidation of partnership.
All of the above reasons require the use of profit and loss ratio. The wait period for the end-of-the-year balances to
determine the average or ending capital would be in exercise of futility because of the urgency of profit and loss ratio.
Deferral of such action would not address the above reasons.

In the United States, in the absence of any agreement, profit or loss should be allocated equally and if they agreed on capital
balances it is presumed to be the average capital. Nevertheless, these are practices which are not applicable under Philippine
setting because of its differing law provisions.

Profits and loss can be shared in many ways among partners of a partnership. Most profit and loss sharing formula includes
one or more of the following features or techniques:
1. Equally;
2. Arbitrary ratio;
3. In the ratio of partner’s capital account balances and the dividing the balance on agreed ratio:
a. Original capital – the initial investment / capital at the time of formation.
b. Beginning capital of the period
c. Average capital
c1. Simple average
c2. Weighted average
c2.1. Peso-day approach
c2.2. Peso-month approach
4. Interest on partners’ capital accounts and dividing the balance on agreed ratio;
5. Salaries to partners and dividing the balance on agreed ratio;
6. Bonus to partners and dividing the balance on agreed ratio; and
7. Interest on capital account balance, salaries and bonus to partners and dividing the balance on agreed ratio
Illustration 18-1: Allocation of Net Income
Assume that a net income of P288,000 is determined for X and Y Partnership at the end of 20x4. Regular withdrawals by partners in
anticipation of net income have been summarized in the drawing accounts; permanent capital changes have been summarized in the
capital accounts. Drawing and capital accounts at the end of 20x4 appear as follows:
X, capital   Y, capital
  1/1/20x4 300,000   3/1/20x4 30,000 1/1/20x4 420,000
  4/1/20x4 60,000     11/1/20x4 60,000
  12/31/20x4 360,000     12/31/20x4 450,000
     
X, drawing Y, drawing
1/1/-12/31 36,000     1/1/-12/31 114,000  
         
36,000     114,000  

Equally

This method may be proper when the capital or service contribution of the partners are considered to be the same.

The entry of the partnership of X and Y to record the allocation of net income of P288,000 equally would be as follows:
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   144,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   144,000

X’s share of net income ½ of P288,000 . . . . . . . . P 144,000

Y’s share of net income ½ of P288,000 . . . . . . . . 144,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000 

The resulting balances in the drawing accounts may be closed into the capital accounts
Arbitrary Ratio

When the capital and service contribution of the partners are unequal, an arbitrary profit ratio may be employed to recognize
these differences.

An infrequently used variation of this method specifies one ratio for profits and a different ratio for losses. Because profit
and loss years may alternate, it is extremely important that profit or loss for each year be determined accurately in all
material respects when this variation is used.

Although agreements to share profits and losses equally or in specified ratios are common, more complex profit sharing
agreements are also encountered in practice. The time that partners devote to the partnership business and the capital
contributed in the business by individual partners are frequently considered in determining the profit sharing agreement.

Assume that, since the expertise, ability, and reputation of X are factors of special significance to the success of the
partnership, X and Y agree to allocate net income in the ratio of 3:2. The entry to record the allocation of net income of
P288,000 is:
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   172,800
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   115,200

X’s share of net income 3/5 of P288,000 . . . . . . P 172,800

Y’s share of net income 2/5 of P288,000 . . . . . . 115,200
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000 
Capital Balances

To avoid argument, it is essential that the partnership contract specifies whether the profit-sharing ratio is based on (1) the
original capital investments, (2) the beginning capital account balances at the beginning of each year, (3) the balances at the
end of each year (before the distribution of net income or loss), or (4) the average balances during each year.

Original Capital. If the agreement between X and Y provides that the allocation of net income shall be based upon original
capitals, reference would be made to the amounts originally invested by the partners.

Beginning Capital. When beginning capital balances are used in allocating partnership profit, additional investments during
the accounting period may be discouraged because the partners making such investments are not compensated in the
division of profit until a later period. Usage of this will prove to be inequitable. Assuming this agreement for X and Y, the
entry to record the allocation of net income of P288,000 for the year is:
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   120,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   168,000
X, capital, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . P 300,000
X, capital, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . 420,000
Total capitals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 720,000
X’s share of net income: 300/720 of P288,000 . . . . P 120,000
Y’s share of net income 420/720 of P288,000 . . . . 168,000
Total capitals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000 
Ending Capital. A similar problem exists when ending capital balances are used. Year-end investments are encouraged by
their inclusion in determining each partner’s share of profit, but no incentive exists for a partner to make any investments
before year-end.

Also, no penalty exists for withdrawals if the amounts withdrawn are reinvested before the period’s end. If the partnership
agreement provides for an allocation of net income based upon partner’s capital at the end of each year, the entry to record
the allocation of net income of P288,000 for the year is:

Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 288,000  

X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   128,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   160,000

X, capital, December 31 . . . . . . . . . . . . . . . . . . . . P 360,000

X, capital, December 31 . . . . . . . . . . . . . . . . . . . . 450,000
Total capitals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 810,000 

X’s share of net income: 360/810 of P288,000 . . . P 128,000

Y’s share of net income 450/810 of P288,000 . . . 160,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000
Average Capital. It must have provided the fairest basis for allocating partnership profit because it reflects the capital actually available
for use by the partnership during the year. An agreement for the use of average capitals also acts as an incentive for additional investments
when these can be profitably employed.

If the partnership contract provides for sharing profit in the ratio of average capital account balances during the year, it should also
state the amount of drawings (refer to Chapter 19 for further discussion on drawing accounts) each partner may make without affecting
the capital account. Any additional withdrawals or investments are entered directly on partners’ capital accounts and therefore influence
the computation of average capital ratio.

The following guidelines should be considered:

• An agreement should indicate clearly what withdrawals or drawings accounts are to be recognized;

• A partnership agreement may state that only withdrawals above a certain limit are to be viewed as offsets (reduction) against
capital balances. It means that drawing account balances up to the amounts specified in the agreement would not be deducted in
determining the partners’ average or year-end capital balances.

• Typically, either personal withdrawals or temporary withdrawals or drawing accounts (which are withdrawal against share in
anticipated profit) are not recognized in the computation of average capital. Conversely, capital withdrawals or permanent
withdrawals (which are withdrawal against original or additional investments) are recognized.

The reason for the non-inclusion of the personal withdrawals in the computation of average capital is that in as much as profits are
generated evenly throughout the year, the figure itself is already an average amount. Mathematically, the resulting figure of
inclusion of such withdrawals or excluded in the average capital computation is exactly the same
The average capital balances for the year can be computed using the following approach:
1. Simple average. This method is not so widely used by accountants in view of its failure to take into consideration the periods of time the changes in
capital take place
2. Weighted average. The partners may wish to recognize all the changes in their capital as well as in their drawing accounts in determining the
capital ratio to be used in distributing the profits or losses in the operation of the partnership. The partnership contract should state whether
weighted capital account balances are to be computed to the nearest day (using daily balances/peso-day approach) or to the nearest month
(beginning-of-month balances or end-of-month balances/peso-month approach.)

For peso-month approach, investments and withdrawals made at the beginning of the month if made before the middle of the month and are to be
considered as made at the beginning of the following month if made after the middle of the month.

If the allocation of net income is to be based upon average (weighted) capitals for the year, the entry to record the allocation of net income of
P288,000 for the year is:
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 288,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   132,480
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   155,520

  Capital   No. of Mos.  

X: balance   Unchanged
1/1/x4: P300,000 x 3 P 900,000
4/1/x4: 360,000 x 9 3,240,000
      12 P4,140,000
Average       P 345,000 

  Capital   No. of Mos.  

Y: balance   Unchanged
1/1/x4: P420,000 x 2 P 840,000
3/1/x4: 390,000 X 8 3,120,000
11/1/x4: 450,000 x 2 900,000
      12 P4,860,000
Average       P 405,000
Total       P 750,000 

X’s share of net income: 345/750 of P288,000. . . P 132,480

Y’s share of net income: 405/750 of P288,000. . . 155,520
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000 
Interest on Capital Balances

The purpose of allowing interest on capital is to give recognition to differences on capital contributions by partners. It
also recognizes the contribution of the partners’ capital contribution to the partnership’s profit-generating-capacity. The
use of interest on capital as a means of allocating profits would be appropriate when the business is capital intensive
versus labor intensive or if the partners were not significantly involved in the day-to-day operations.

Interest on Capital as a Distribution/Allocation of Net Income. Using interest allowances on partners’ capital accounts as
a technique for sharing partnership profit equitably has no effect on the measurement of net income or loss of the
partnership.

Remember that the partners’ capital contributions are just that – they are not loans to the partnership. Accordingly, it is
not appropriate to charge an Interest Expense account and an Interest Payable account, because interest on partner’s
capital account is not an expense of the partnership.
Assume that X and Y agree to allow interest on average capital at 6%; any net income or loss balance is to be allocated 3:7.
Assuming no entries for interest during the course of the year, entries to record the allowance of interest and the remaining
allocation of net income follow:
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   20,700
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   24,300

X’s interest on average capital: 6% of P345,000 . . . P 20,700

Y’s interest on average capital: 6% of P405,000 . . . 24,300
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 45,000 

Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243,000  

X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   72,900
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   170,100

  X Y Total
Interest on average capital P 20,700 P 24,300 P 45,000
Balance (3:7)………………... 72,900 170,100 243,000
Total ………………………….. P 93,600 P194,400 P288,000

The allocation of net income may be summarized in a single entry as follows:

Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   93,600
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   194,400
Interest on Capital Accounts with Resultant Net Loss

If the partnership contract provides for allowing interest on capital accounts, this provision must be enforced
regardless of whether operations are profitable or unprofitable.

The only justification for omitting the allowance of interest on partners’ capital accounts during a loss year
would be in the case of a partnership contract containing a specific provision requiring such omission. After the
entry for interest in such a case, the debit balance in the income summary account is transferred to the partners’
drawing accounts in the profit-and-loss ratio.

In case of loss, the interest allowed to the partners shall be added to the net loss and the total resulting loss
shall be distributed in the ratio agreed upon by the partners for the distribution of the balance after allowance
of interest.
For example, assume that operations for X and Y prior to the recognition of interest had resulted in a net loss of P80,000 and any balance
will be allocated into 1:4 ratio.

Entries to close the income summary account would have been as follows:
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   20,700
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   24,300
Interest allowed based on average capitals.    
X’s interest on average capital: 6% of P345,000 . . . . . P 20,700
Y’s interest on average capital: 6% of P405,000 . . . . . 24,300
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 45,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000  
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000  
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   125,000

The net effect of the foregoing on capitals is:

  X Y Total
Interest on average capital P 20,700 P 24,300 P 45,000
Balance (1:4)………………... ( 25,000) (100,000) (125,000)
Total…………………………… (P 4,300) (P75,700) (P80,000) 
The allocation of net income may be summarized in a single entry as follows:
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300  
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,700  
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   80,000
Partners can provide by agreement that net income or loss shall be allocated in some arbitrary manner without recognition of interest when
the results from operations fail to cover a specified interest allowance.
Interest on Excess Capital Balance. It may be agreed to allow interest on the excess of the average capital of one partner
over that of another. If these were the agreement between X and Y, the entry to record interest and the balance in net income
assuming 1:2 ratio is:
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600  
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   3,600
Interest allowed based on average capitals.    
Y’s interest on excess average capital:
6% of (P405,000 - P345,000) . . . . . . . . . . . . . . . . . . P 3,600

Income summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284,400  

X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   94,800
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   189,600

The net effect of the foregoing on capitals is:

  X Y Total
Interest on excess   P 3,600 P 3,600
average capital
Balance (1:2) P 94,800 189,600 284,400
Total P 94,800 P 193,200 P288,000

The allocation of net income may be summarized in a single entry as follows:

Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   94,800
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   193,200
Interest on temporary advances or loans. When a partnership makes a temporary advance to a partner or receives an
amount as a temporary loan from a partner and these transactions are recognized as creating debtor — creditor
relationships between the partner and the partnership, interest charges and credits on such transactions are recognized
as interest-expense-interest-income.

Interest accruals are recognized periodically on these items just as other receivable and payable balances. When settlement
for interest is made by cash, entries to record the collection of interest or the payment of interest are made in the usual
manner.

When settlement is not to be made in cash but by adjustments to partners’ capitals, interest on an advance to a partner is
recorded by a charge to the partner’s drawing account and a credit to Interest Income, interest on a loan made by a partner to
the partnership by a charge to Interest Expense and a credit to the partner’s drawing account.

In summary, interest on loans from partners is recognized as expense and as a factor in the measurement of net income
or loss of the partnership. Similarly, interest earned on loans is recognized as partnership revenue. This is consistent with
the principle that loans from partners are assets and liabilities, respectively.
Personal Services Rendered in Net Income and Loss Sharing Agreements

Partners may wish to provide for an allocation of net income that recognizes differences in their
abilities and experience or in the time devoted by them to business. Partners may agree to an arbitrary
ratio for this purpose.

However, the use of an arbitrary ratio to recognize personal differences is subject to the same
limitations as those found in the use of the capital ratio to recognize capital differences; i.e., it may
fail to provide satisfactory recognition of the several factors contributing to the success of the
partnership and it may prove inequitable in the event of loss when the partner who has made the
greater personal contribution to the partnership is charged with the greater part of the loss
Salary Allowances

In recognizing differences in personal contribution as well as other factors that are responsible for the
success of the partnership, it may be agreed that partners shall be allowed salaries, with any net income or
loss balance after salaries divided in some arbitrary ratio. Philippine partnership law makes no provision for
remuneration for partner’s services in the absence of an agreement, so it is up to the partners to agree on what is
just and fair compensation.
A partner who devotes time to the partnership business while the other partners work elsewhere may receive
a salary allowance. Salary allowances are also used to compensate for differences in the fair value of the
talents for partners, all of whom devote their time to the partnership.

The purpose of salary allowances are means of achieving a fair division of profit among the partners based
on the time and talents devoted to partnership business. Salaries to partners are often included as part of the
profit distribution plan to recognize and compensate for differing amounts of personal services partners
provide to the business
To illustrate the effect of a salary arrangement, assume that X and Y agree to the allowance of monthly salaries of P10,000
and P9,000, respectively; any net income or loss balance to be allocated in the ratio of beginning capital. Amounts actually
withdrawn by partners during the year were recorded in their drawing accounts as presented in the original problem. The net
income of P288,000 before recognition of salaries is allocated to the partners by the following entries:
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   120,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   108,000
X: Salary for 12 months at P10,000 per month . . . . P120,000
Y: Salary for 12 months at P9,000 per month . . . . . 108,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P228,000 
Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   25,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   35,000

The net effect of the foregoing on capitals is:

  X Y Total
Salaries P120,000 P108,000 P228,000
Balance (300:420) 25,000 35,000 60,000
Total P145,000 P143,000 P288,000 

The allocation of net income may be summarized in a single entry as follows:

Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000  
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   145,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   143,000
Salary Allowances with Resultant Net Loss

When an agreement provides for salaries without qualification, salary allocations must be made even though profit is
inadequate to cover salaries or there is a loss. After salaries are recorded, the income summary account shows a debit
balance that is transferred to the partners’ accounts as agreed.

Bonuses

Bonuses are sometimes used as a means of providing additional compensation to partners who have provided services to the
partnership. Bonuses are typically stated as a percentage of profit either before or after the bonus.

In the absence of any agreed basis, bonus is computed on the basis of partnership net income and the concept of
“partnership net income” is generally understood in accounting practice (i.e., before bonuses are deducted.)

However, partnership agreement should be precise in specifying the measurement procedures to be used in determining the
amount of the bonus.

As with interest on capitals and salary allowances, a bonus should be considered as a distribution of profit and not to be
charged to an expense account.

Sometimes the partnership agreement requires a minimum profit to be earned before bonus is calculated.
Illustration 18-2: Allocation of Net Income with Bonus.
The net income of A and B Partnership for 20x4 amounted to P420,000. A, as the managing partner, is allowed
as a bonus based on the following assumptions:
A. A bonus of 20% of net income before the bonus is deducted, the bonus would be computed as follows:
Let B = Bonus
B = 20% of Net income
B = 20% of P420,000
B = P84,000

B. A bonus of 20% of net income after deduction of the bonus, the bonus would be computed as follows:
Let B = Bonus
B = 20% of Net income after Bonus
B = 20% (P420,000 – B)
B = P84,000 - .20B
1.20 B = P84,000
B = P70,000
As a general rule, when the partnership provides without qualification that bonus is to be allowed, bonus should
be based on net income before deduction of bonus.
Basis of Computation for Bonus

As long as the basis of computation for bonus will be a positive amount, the resulting bonus should always be allocated to partners entitled to it,
regardless of the availability of the residual amount.

Illustration 18-3: Allocation of Net Income with Bonus, Salaries, Interest and Income tax.
Refer to Illustration 18-2, assume that the partners further agreed on the allocation of net income:
• Bonus of 20% to A;
• Salaries to A, P40,000 and B, P60,000;
• Interest on average capital balances – A, P12,000 and B, P8,000.
• Residual balance in net income be allocated to A and B in the ratio of 2:1 ratio

The following assumptions for bonus are considered:

1. Bonus is based on net income before bonus, salaries and interest – same as Illustration 18-2 (A)
The schedule showing the allocation of net income is presented as follows:
  A B Total
Bonus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 84,000   P 84,000
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 P 60,000 100,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 8,000 20,000
Balance (2;1) . . . . . . . . . . . . . . . . . . . . . . . . . 144,000 72,000 216,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P280,000 P140,000 P420,000

2. Bonus is based on net income after bonus but before salaries and interest - same as Illustration 18-2 (B).
The schedule showing the allocation of net income is presented as follows:
  A B Total
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 70,000   P 70,000
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 P 60,000 100,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 8,000 20,000
Balance (2;1) . . . . . . . . . . . . . . . . . . . . . . . . . 153,333 76,667 230,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P275,333 P144,667 P420,000
3. Bonus is based on net income after bonus and salaries but before interest:
Let B = Bonus; S = Salaries; and I = Interest
B = 20% of Net income after Bonus and Salaries before Interest
B = 20% (P420,000 – B – S)
B = 20% (P420,000 – B – P100,000)
B = 20% (P320,000 – B)
B = P64,000 - .20B
1.20 B = P64,000
B = P53,333
Note: It should be noted that the term “before” used in the allocation of net income particularly in the computation of bonus does not give any sense at all because the general rule as to the interpretation of “net income”
means it is before deduction of bonus, salaries to partners and interests on capital. These three elements (bonus, salaries to partners and interest on capital) of allocation of net income are not expenses of the partnership but
merely as a distribution or allocation of net income

Proof:
Net income before bonus, salaries and interests . . . . . . . . . . . . . . . . . . P420,000
Less: Bonus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,333
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Net income after bonus, salaries before interests . . . . . . . . . . . . . . . . . P266,667
Multiplied by: Bonus rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20%
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 53,333

The schedule showing the allocation of net income is presented as follows:

  A B Total
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 53,333   P 53,333
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 P 60,000 100,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 8,000 20,000
Balance (2;1) . . . . . . . . . . . . . . . . . . . . . . . . . 164,445 82,222 246,667
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P269,778 P150,222 P420,000
4. Bonus is based on net income after bonus, salaries and interest:
Let B = Bonus; S = Salaries; and I = Interest
B = 20% of Net income after Bonus and Salaries before Interest
B = 20% (P420,000 – B – S – I)
B = 20% (P420,000 – B – P100,000 – P20,000)
B = 20% (P300,000 – B)
B = P60,000 - .20B
1.20 B = P60,000
B = P50,000

Proof:
Net income before bonus, salaries and interests . . . . . . . . . . . . . . . . . . . P420,000
Less: Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Net income after bonus, salaries before interests . . . . . . . . . . . . . . . . . P250,000
Multiplied by: Bonus rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20%
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 50,000 

The schedule showing the allocation of net income is presented as follows:

  A B Total
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 50,000   P 50,000
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 P 60,000 100,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 8,000 20,000
Balance (2;1) . . . . . . . . . . . . . . . . . . . . . . . . . 166,667 83,333 250,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P268,667 P151,333 P420,000
5. Bonus is based on net income after salaries but before bonus and interest:

Let B = Bonus; S = Salaries; and I = Interest

B = 20% of Net income after Salaries before Bonus and Interest
B = 20% (P420,000 – S)
B = 20% (P420,000 – P100,000)
B = 20% (P320,000)
B = P64,000

Refer to Note of No. 3.

6. Bonus is based on net income after interest but before bonus and salaries:
Let B = Bonus; S = Salaries; and I = Interest
B = 20% of Net income after Interest before Bonus and Salaries
B = 20% (P420,000 – P20,000I
B = 20% (P400,000)
B = P80,000
Refer to Note of No. 3
7. Bonus is based on net income before bonus but after income tax (tax rate is 35%):
Let B = Bonus;
B = 20% (P420,000 – T)
B = P84,000 - .20T
Let T = Income tax
T = 35% (P420,000)
T = P147,000

Substituting the equation for T in the equation for B:

Let B = P84,000 - .20 (P147,000)
B = P84,000 – P29,400
B = P54,600
Proof:
Net income before bonus and income tax . . . . . . . . . . . . . . . . . . . . . . P420,000
Less: Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,600
Net income after bonus before income tax . . . . . . . . . . . . . . . . . . . . P365,400
Less: Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . _147,000
Net income after bonus and income tax . . . . . . . . . . . . . . . . . . . . . . P218,400
Bonus as computed above
Net income before bonus and income tax . . . . . . . . . . . . . . . . . . . . . . . . P420,000
Less: Income tax (35% x P420,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147,000
Net income after income tax before bonus . . . . . . . . . . . . . . . . . . . . . . P273,000
Multiplied by: Bonus rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20%
Net income after bonus and income tax . . . . . . . . . . . . . . . . . . . . . . . . P 54,600
8. Bonus is based on net income, that is, after bonus and income tax:
Let B = Bonus; T = Income tax
B = 20% (P420,000 – B – T)
B = P84,000 – .20B – .20T
Let T = Income tax
T = 35% (P420,000)
T = P147,000

Substituting the equation for T in the equation for B:

Let B = P84,000 – .20B – .20T
B = P84,000 – .20B – .20 (P147,000)
1.20B = P84,000 – P29,400
1.20B = P54,600
B = P45,500

Proof:
Net income before bonus and income tax . . . . . . . . . . . . . . . . . . . . . . P420,000
Less: Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,500
Net income after bonus before income tax . . . . . . . . . . . . . . . . . . . . . . . . . . P374,500
Less: Income tax (35% x P420,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147,000
Net income after bonus and income tax . . . . . . . . . . . . . . . . . . . . . . . . P227,500 

Bonus as computed above:

Net income after bonus and income tax . . . . . . . . . . . . . . . . . . . . . . . . P227,500
Multiplied by: Bonus rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ 20%
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 45,500
Bonus with Resultant Net Loss

The concept of bonus is not applicable to a net loss. When a partnership operates at a loss, the bonus provision
is disregarded because it defeats the purpose of giving bonus.

Insufficient Income to Cover Allocation

In some cases, the partnership net income may be less than the interest, salary and/or bonus provided for in
the partnership agreement.

If the partners fail to provide for such an occurrence in the profit and loss formula, the established practice
is to allocate the interest, salary and/or bonus as if sufficient income had been earned. The amount by which
the interest, salary and/or bonus exceeds the net income is allocated to the individual partners in their agreed
ratio for allocating residual income.

Therefore, it is simply satisfying all provisions of the profit and loss agreement. This procedure should also be
followed when the partnership has an overall loss (see previous discussion on interest, salary and bonus with a
resultant net loss).
Special Problems in Allocation of Profit and Loss - Salaries and Interest as an Expense

In the previous discussions, net income was viewed as the return to the partners for their full contribution to the
business as owners – capital as well as personal service. Interests and salary allowances to partners were regarded as
a means of providing for an equitable distribution of such income.

It is possible to record salaries and interest as part of expense items rather than as distribution or allocation of net
income.

When these items are made to expense accounts rather than to the partners’ drawing accounts (or capital accounts); expense
balance are then closed into the Income Summary account in arriving at the net income to be allocated in the agreed profit
and loss ratio.

On the income statement, partners’ interest and salaries would be listed with the other expenses in arriving at net income or
loss of the partnership.

Whether partners’ interest and salaries are treated in the accounts as expense items or as distributions or allocation of net
income, the eventual distribution or allocation of partnership net income or loss among the partners remain exactly the
same.
Corrections of Partnership Net Income of Prior Period

Errors may occur in accounting for partnership operations, such as failure to accrue or defer expenses or
revenue errors in the inventory count or pricing, or errors in the calculation or amortization of assets.

Problems in the allocation of profit and loss can result if (1) errors are discovered that occurred in specific prior
years, and (2) the partners have altered the profit and loss agreement since the period in which the error
occurred. In corporation, an error correction is accounted for as an adjustment to the beginning retained
earnings balance.

However, in a partnership the correction is allocated to the individual partners’ capital accounts. The allocation
should be based on the profit and loss agreement in effect during the period of the error.
Subsequent Changes in Methods to Allocate Net Income or Loss

If the partners subsequently agree to change the method to allocate profit and losses, equity dictates that assets
be revalued to their current values at the time of the change.

For example, assume that partners X and Y shared profits and losses in a 6:4 ratio respectively, but at a later
date agreed to share profits and losses equally. Suppose that the partnership holds a piece of machinery carried
on the books at P100,000, but with a P140,000 current value. Partner Y would receive a larger share of the
profit on the machinery (when it is later sold) than had the machinery been sold before the change in the
method to share profits and losses were shared 6:4 ratio.

As an alternative to revaluing the machinery to its current value to stipulate in the new profit-sharing formula
that the first P40,000 of profit on the sale of that machinery is to be shared in the old profit and loss sharing
ratio.

Under this method, the partnership avoids making an entry that is different with what is Generally Accepted
Accounting Principles (GAAP). This is not a major reason for selecting this alternative, however, if revaluing
assets is more practical
When the profit and loss sharing formula is revised, the new formula should contain a provision specifying
that the old formula applies to certain types of subsequent adjustments arising out of activities that took
place before the revision date. Examples are as follows:
1. Unrecorded liabilities at the revision date;
2. Settlement on lawsuits not provided for at the revision date, even though the liability may not have
been probable as to payment or reasonably estimate at that time;
3. Write-offs of accounts receivable existing as of the revision date.

Regardless of the fact that some of these items do not qualify as prior period adjustments greater equity is
usually achieved among the partners by using the old sharing formula. Because partnerships need not follow
GAAP, the will of the partners may prevail.
Special Profit Allocation Methods

Some partnerships distribute net income on the basis of other criteria. For example, most public accounting partnerships
distribute profit:
1. On the basis of partnership “units”. A new partner may acquire a certain number of units, and additional units
are assigned by a partnership compensation committee for obtaining new clients, or for providing the firm with
specific areas of industrial expertise
2. Performance methods. It gives some weight to the specific performance of each partner to provide incentives to
perform well. Some examples of the use of performance criteria are listed below:
a. Chargeable hours. These are the total number of hours that a partner incurred on client-related assignments.
Weight may be given to hours in excess of normal.
b. Total billings. The total amount billed to clients for work performed and supervised by a partner constitutes
total billings. Weight may be given to billings in excess of normal
c. Write-offs. Write-offs consist of the amount of uncollectible billings. Weight may be given to a write-off
percentage below normal
d. Promotional and civic activities. Time devoted to developing future business and enhancing the partnership
name in the community is considered promotional and civic activity. Weight may be given to time spent in
excess of normal or to specific accomplishments resulting in new clients
e. Profits in excess of specified level. Designated partners commonly receive a certain percentage of profits in
excess of a specified level of earnings
Statement of Changes in Partners’ Capital Accounts

The balance sheet and income statement for a partnership are accompanied by a third statement that reports the changes that have taken place in the
partners’ interests during the period. The statement of changes in partners’ capital accounts based on Illustration 18-1 (assuming that 6% interest is
based on average capital with the remaining net income be allocated based on a 3:7 ratio for X and Y, respectively) may be prepared in the following
manner:

X and Y Partnership
Statement of Changes in Partner’s Capital Accounts
For the Year Ended, December 31, 20x4
  X Y Total
Capitals, January 1, 20x4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P300,000 P420,000 P 720,000
Add: Additional Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 60,000 120,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P360,000 P480,000 P 840,000
Less: Capital withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -0- 30,000 30,000
Ending Capital before Net Income . . . . . . . . . . . . . . . . . . . . . . P360,000 P450,000 P 810,000
Add: Net Income (see schedule) . . . . . . . . . . . . . . . . . . . . . . . 93,600 194,400 288,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P453,600 P644,400 P1,098,000
Less: Personal withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000 114,000 150,000
Capitals, December 31, 20x4 . . . . . . . . . . . . . . . . . . . . . . . . . . . P417,600 P530,400 P 948,000 

X and Y Partnership
Schedule – Allocation of Net Income
For the Year Ended, December 31, 20x4
  X Y Total
Interest on average capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 20,700 P 24,300 P 45,000
Balance (3:7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,900 170,100 243,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 93,600 P194,400 P288,000