Ateneo de Naga University College of Business and Accountancy Accountancy Department Partnership Accounting Partnership Operations
Concepts and Problems
Division of profits and losses The Partnership Law provides that if the profit allocation 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 on 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 contributions), 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 refer 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.
Methods of profit and and loss allocation allocation Profit 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 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) Ending capital of the period d) Average capital d1) Simple average d2) Weighted average d2.1) Peso-day approach d2.2) 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 7) Interest on capital account balance, salaries and bonus to partners and dividing the balance on agreed ratio. Because of its simplicity, the equally or the arbitrary ratio approach is the most common of allocating profit or loss. It is simple because it ignores capital balances. Assigning profit based equally or on an arbitrary ratio may be simple, but this approach is not necessarily equitable to all partners. No single ratio is likely to reflect properly the various contributions made by a partner. Indeed, an unlimited number of alternative allocation plans could be devised in hope of achieving fair treatment for all parties.
Details about profit and loss allocation methods 1) Equally – this method may be proper when the capital or service contribution of the partners are considered to be the same. 2) Arbitrary ratio – this method may be employed to recognize the difference in capital and service contribution of the partners. 3) Capital balances – this method is not only easy to apply but can also prevent certain inequities from occurring among partners if the partnership is liquidated. 4) Original capital – the reason behind the usage of original 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.
1 | Page
5) Beginning capital – when this is used, additional investment during the accounting period may be discouraged because partners making such investments are not compensated in the division of profit until a later period. 6) Ending capital – under this method, year-end investments are encourage 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. 7) 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. NOTE: If the partnership contract provides for sharing profit in the ratio of average
capital balances during the year, it should also state the amount of drawings each partner may make without affecting the capital account. Any withdrawals or investments are
entered
directly
on
partners’
capital
accounts
and
therefore
influence
the
computation of average capital ratio. 8) 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. 9) Weighted average – the partnership may wish to recognize all the changes in their capital as well as in their drawing accounts in determining the distributing profits or losses in the operation of the contract should state whether weighted capital balances are day (peso-day approach) or to the nearest month (peso-month
capital ratio to be used in partnership. The partnership to be computed to the nearest approach)
NOTE: 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. 10) Interest on capital balances – the purpose of allowing interest on capital is to give recognition to difference on capital contributions by partners. It also recognizes the contribution of the partner s’ capital 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 of if the partners were not significantly involved in the day-to-day operations. NOTE: a) Interest on capital balances is not an expense of the partnership; however, interest on loan payable to partners is a n interest expense of the partnership. b) Interest on capital balances shall be enforced regardless of whether operations are
profitable or not. 11) Salary allowances – 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. NOTE: a) Salary allowances are not expense of the partnership since partners are not employees of the partnership. It is just a tool of allocating profit among the partners. b) Salary allocations must be made even though profit is inadequate to cover salaries or
there is a loss. 12) Bonuses – these 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 e ither before or after the bonus. When s ilent, it’s before the bonus NOTE: 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.
2 | Page
Illustrative Problem #1 Assume that a net income of P288,000 is determined for X and Y Partnership at the end of 2014. 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 2014 appear as f ollows: X, capital
Y, capital
1/1/2014 4/1/2014 12/31/2014
P300,000 60,000 P360,000
3/1/2014
P30,000
X, drawing
1/1/2014 11/1/2014 12/31/2014
P420,000 60,000 P450,000
Y, drawing
1/1-12/31
P36,000
1/1–12/31
P114,000
12/31/2014
P36,000
12/31/2014
P114,000
Required: Determine the share of each partner in the net income assuming: 1) Net income would be allocated equally among X and Y.
2) 3) 4) 5) 6) 7) 8)
X and Y agree to allocate net income in the ratio of 3:2. Allocation of net income shall be based upon original capitals. Beginning capital balances are used in allocating partnership profit. Allocation of net income shall be based upon partner’s capital at the end of each y ear.
Allocation of net income shall be based upon simple average capitals for the year. Allocation of net income shall be based upon weighted average capitals for the year X and Y agree to allow interest on average capital at 6%; any net income or loss balance is to be allocated at the ratio of 3:7. a) Same interest was allowed but assuming the partnership incurred a net loss of P80,000 and any balance will be allocated into 1:4 ratio. 9) The partners agree to allow interest of 6% on the excess of the average capital of one partner over that of another and the balance in net income would be allocated in 1:2 ratio. 10) X and Y agree to the allowance of monthly salaries of P10,000 and P9,000 respectively; any net income or loss b alance is to be allocated in the ratio of beginning capital.
Illustrative Problem #2 The net income of A and B Partnership managing partner, is entitled to bonus.
for
2014
amounted
to
P420,000.
A,
as
the
Required: Determine the bonus of A assuming it is based on: 1) A bonus of 20% of net income before bonus is deducted. 2) A bonus of 20% of net income after deduction of the bonus.
Illustrative Problem #3 Refer to illustrative problem number 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.
Required: 1) Determine the share of each partner in t he net income assuming:
a) b) c) d)
Bonus Bonus Bonus Bonus
is is is is
based based based based
on on on on
net net net net
income income income income
before bonus, salaries, and interest. after bonus but before salaries and interest. after bonus and salaries but before interest. after bonus, salaries and interest.
2) Compute the a) Bonus is b) Bonus is c) Bonus is d) Bonus is
bonus based based based based
of on on on on
A a ssuming: net income after salaries but before bonus and interest. net income after interest but before bonus and salaries. net income before bonus but after income tax (tax rate is 35%). net income, that is after bonus and income tax. 3 | Page
Exercises Allocation of Net income 1) Assume that a net income of P345,600 is determined for 2015. Regular withdrawals by partners in anticipation of the drawing accounts; permanent capital changes have been Drawing and capital accounts at the end of 2015 appear as
X and Y Partnership at the end of net income have been summarized in summarized in the capital accounts. follows:
X, capital
1/1/2015 4/1/2015 12/31/2015
Y, capital
P360,000 72,000 P432,000
3/1/2015
P36,000
X, drawing
1/1/2015 11/1/2015 12/31/2015
P504,000 72,000 P540,000
Y, drawing
1/1-12/31
P43,200
1/1–12/31
P136,800
12/31/2015
P43,200
12/31/2015
P136,800
: Prepare journal entries to allocate net income based on: Required a) Beginning capital b) Ending capital c) 6 percent interest on excess average capital balance and the balance allocated in the ratio of 1:2.
Computation of Bonus 2) The net income of Ey and Bi Partnership for 2015 amounted to P504,000. Ey, as the managing partner, is allowed as a bonus. : Determined the amount of bonus, assuming: Required a) Bonus of 20 percent of n et income before the bonus is deducted (bonus is treated as an allocation of distribution of net income). b) Bonus of 20 percent of n et income after deduction of the bonus (bonus is treated as an expense in computing the bonus amount). 3) Roger and Michael formed a partnership on January 2, 2015. Michael invested P120,000 in cash. Roger invested land valued at P30,000, which he had purchased for P20,000 in 2011. In addition, Roger possessed superior managerial skills and agreed to manage the firm. The partners agreed to the following profit and loss allocation formula:
Interest – 8 percent on original capital investments.
Salary – P5,000 a month to Roger.
Bonus – Roger is to be allocated a bonus of 20 percent of net income after subtracting the bonus, interest, and salary. Remaining profit is to be divided equally.
At the end of 2015, the partnership reported net income before interest, salaries, and bonus of P168,000. : Calculate the amount of bonus to be allocated to Roger. Required
Computation of Average Capital 4) James, Keller and Rivers have the following capital balances; P48,000, P70,000 and P90,000 respectively. Because of cash shortage, James invests an additional P12,000 on June 1. Each partners withdraws P1,000 per month. James, Keller and Rivers receive a salary of P13,000, P15,000 and P20,000 respectively, for work done during the year. Each partner receives interest of 8 percent on their weighted average capital balance without regard to normal drawings. Any remaining profits are split 20%, 30% and 50% respectively. The net income for the year is P30,000. Required: What are the ending capital balances for each partner?
4 | Page
Allocation of Net income with Bonus, Salaries, Interest and Income Tax 5) The net income of Ex and Way Partnership for 2015 amounted to P504,000. Ey, is the managing partner. Assume that the partners agreed o n the allocated on net income as follows:
Bonus of 20 percent to A;
Salaries to A, P48,000 and B, P72,000;
Interest on average capital balances – A, P14,400 and B, P9,600.
Residual balance in net income be allocated to A and B in the ratio of 2:1
: Prepare a schedule to allocate net income, assuming: Required a) b) c) d) e) f) g) h)
Bonus Bonus Bonus Bonus Bonus Bonus Bonus Bonus
is is is is is is is is
based based based based based based based based
on on on on on on on on
net net net net net net net net
income before bonus, salaries and interest. income after bonus but before salaries and interest. income after bonus and salaries but before interest. income after bonus, salaries and interest. income after salaries but before bonus and interest. income after interest but before bonus and salaries. income before bonus but after income tax (tax rate is 35%) income, that is, after bonus and income tax of 35%.
Allocation of Net income with Multiple Bases 6) Ace, Mark, and Ric are partners in a business which manufactures garden tools. Their profit and loss agreement has the following provisions:
Salaries of P40,000, P20,000 and P45,000 for Ace, M ark, and Ric respectively.
Mark will receive a bonus equal to 5 percent of sales in excess of P1,000,000.
All partners will receive a bonus of 10% of net income in excess of P150,000 after the total of all such bonuses. Partners will be allocated interest on their weighted-average capital Drawings in excess of annual salaries will be considered reduction in Interest is computed at the rate of 10 percent.
balance. capital.
Remaining profits and losses will be allocated 35%, 25% and 40% to Ace, Mark, and Ric respectively, Gains and losses from the sale of depreciable assets will be excluded from the above provisions and will be equally allocated among the partners.
Activity in the partners’ capital and drawing accounts during the year was as follows:
Ace, capital Beginning balance February 1 March 31 June 1 June 30 August 1 September 30 Ending balance
P 75,000
Ace, drawings P
0 15,000 10,000
Mark, capital P125,000
Mark, drawings P
0 25,000 5,000
Ric, capital P 40,000 30,000
Ric, drawings P
0 15,000
10,000 10,000
5,000
15,000
10,000 P 85,000
P 45,000
15,000 P125,000
P 35,000
P 70,000
P 45,000
: Determine how the annual net income of P200,000 (including a gain on the sale of Required equipment of P15,000 should be allocated among partners. Annual sales revenue was P1,100,000.
5 | Page
