Notes

Financial Accounting & Reporting

Module-3 Partnership Operation

NATURE OF PARTNERSHIP OPERATION

Basically accounting for partnership operations and accounting for the operations of a
sole proprietorship is essentially the same. Steps of the accounting cycle and the rule of debit
and credit to record the transactions are also the same for both sole proprietorship and
partnership. Purchased of office chairs and table on account is debited to Furniture and Fixtures
and credited to Accounts Payable. Payment of expenses is debited to Expenses and credited to
Cash. 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.
At the end of the accounting period, adjustments are made for merchandise inventory,
accruals, prepayments, provision for uncollectible accounts, and provision for depreciation.
Profit or loss is determined in the usual manner, that is, by matching periodic income and
expense

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 other nominal accounts with credit balances
(such as Purchases Discounts and Purchases Returns and Allowances) 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 Discounts and Sales Returns and
Allowances) are credited. Third, the balance of the Income Summary account, which
represents profit or loss of the partners. Finally, the balance of the drawing account of each
partner is transferred to his/her 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. A credit balance in the Income Summary account represents
a profit and its balance is transferred to the drawing accounts of the partners based on their
profit and loss sharing ratio

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The entry is as follows:

Income Summary xxx

X, Drawing xxx
Y, Drawing xxx

Any resulting credit balance in the drawing account of a partner may be withdrawn by the
partner or reinvested into the firm. If the balance in the drawing accounts is withdrawn in cas,
the entry is as follows:

X, Drawing xxx
X, Cash xxx

However if the partner decides to reinvest into the firm this balance in his drawing account, the
entry is as follows:

X, Drawing xxx
X, Capital xxx

A debit balance in the Income Summary account represents a loss and its balance is
transferred to the drawing accounts of the partners based on their profit and loss sharing ratio.
The entry is as follows:

X Drawing xxx
Y, Drawing xxx
Income Summary xxx

The resulting debit balance in the drawing account of a partner is charged against his capital
with the following entry:

X, Capital xxx
X, Drawing xxx

On the other hand, the balance of the Income Summary account may be transferred directly to
the capital accounts of the partners if the partners ’intention is to make the profit or loss 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 mentioned, pertaining to distribution
of profit or loss are recorded directly to the capital accounts with the assumption that partners
intend to make their respective share on the profit loss as a direct part of their permanent
capital.

A credit balance in the Income Summary account represent a profit and its balance is
transferred to the capital accounts of the partners based on their profit and loss sharing ratio.
The entry is as follows:

Income Summary xxx

X, Capital xxx
Y, Capitall xxx

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A debit balance in the Income Summary account represents a loss and its balance is transferred
to the capital accounts of the partners based on their profit and loss sharing ratio.
The entry is as follows:

X, Capital xxx
Y, Capital xxx
Income Summary xxx

DISTRIBUTION OF PROFIT AND LOSSES

To make distribution of partnership profits and losses equitable, the following factors are
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

RULES FOR DIVIDING PROFITS AND LOSSES

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 contributions after satisfying the share of the industrial partner on such profit.
The following is the list of rules in the division of profits and losses of the partnership
based on the provision of the New Civil Code:

1. As to Capital Partners
a. Division of profits
1. in accordance with agreement
2. in the absence of an agreement, division of profits is in accordance with capital
contributions55
b. Division of losses
1. In accordance with agreement
2. If only division of profits is agreed upon, the division of losses will be the same as
the agreement on the division of profits
3. In the absence of an agreement, division of losses is in accordance with capital
contributions

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

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METHODS OF DISTRIBUTING PROFITS BASED ON PARTNERS ’AGREEMENT
1. 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.

2. 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 operations.

3. 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 partner may devote in running the firm’s business operations. Interest is allowed to
partners for the use of invested capital. Interest as agreed by the partners shall be
allowed in proportion over the period such capital was actually used. Moreover, the
interest shall be provided whether profit is sufficient or insufficient or there is a net loss
unless otherwise agreed upon by the partners.

4. 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 operations
but does not take into consideration the differences in capital contributions.
Salaries are allowed to partners as a compensation for their time devoted in the
business. Salaries as agreed by the partners shall be allowed in proportion to the time
the partners actually rendered services to the firm. Such salaries shall be provided
whether the profit is sufficient or insufficient or there is net a loss unless otherwise
agreed upon by the partners.56

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

6. Interest on capital, salaries to partners, bonus to managing partner, and the balance on
agreed ratio.

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Illustrative Problem : The following accounts and balances are available in the books of

Ciara and Dolly Partnership for the year 2019.

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Case 1- Profit is divided in the ratio of 75% and 25% to Ciara and Dolly
Income Summary 800,000
Ciara, Capital 600,000
Dolly, Capital 200,000
P800,000 x 70% = P600,000
P800,000 x 25% = P200,00057

Case 2- Profit is allocated based on the beginning capital ratio

Income Summary 800,000
Ciara, Capital 476,676
Dolly, Capital 324,324
P800,000 x 2,200/3,700 = P475,676
P800,000 x 1,500/3,700 = P324,324

Case 3- Profit is allocated based on the ending capital ratio

Income Summary 800,000
Ciara, Capital 486,957
Dolly, Capital 313,043
P800,000 x 2,800/4,600 = P486,957
P800,000 x 1,800/4,600 = P313,043

Case 4 - Profit is allocated based on the average capital ratio.

Income Summary 800,000
Ciara, Capital 490,678
Dolly, Capital 309,322
P800,000 x 2,412,500/ 3,933,333.33 = P490,678
P800,000 x 1,520,833.33/ 3,933,333.33 = P309,322
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 using
the peso month method; 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 represents peso month and divide the total by twelve (12) to
obtain the average monthly capital.
By following the steps given, the average capital of each partner can be calculated as follows:

Ciara, Average Capital

No. of Mos.
Period Capital Balance Unchanged Peso Months
Average
Capital
Jan.1 – Mar.31 P2,200,000 3 P 6,600,000
Apr. 1 – Apr.30 2,450,000 1 2,450,000
May 1 – Sept.30 2,300,000 5 11,500,000
Oct. 1 – Dec. 31 2,800,000 3 8,400,000

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 12 P28,950,000
P2,412,500

Dolly, Average Capital58

Jan.1 – Apr. 30 P1,500,000 4 P 6,000,000
May 1– Sept. 30 1,350,000 5 6,750,000
Oct. 1 – Nov. 30 1,850,000 2 3,700,000
Dec. – Dec. 31 1,800,000 1 1,800,000
12 P18,250,000
P1,520,833.33

P3,933,333.33

Case 5- Each partner is allowed 12% interest on ending capital and the remaining profit is
divided equally
Income Summary 800,000
Ciara, Capital 460,000
Dolly, Capital 340,000
Alternative entry to record the distribution of profits may be recorded separately as follows:
Income Summary 552,000
Ciara, Capital 336,000
Dolly, Capital 216,000
Interest on ending capital.

Income Summary 248,000

Ciara, Capital 124,000
Dolly, Capital 124,000
Remaining income divided equally

Division of profit
Ciara Dolly Total
Interest on ending capital
P2,800,000 x 12% P336,000
P1,800,000 x 12% P216,000 P552,000
Remainder-equally
P248,000 /2 124,000 124,000 248,000
Totals P460,000 P340,000 P800,000

Case 6- Ciara is allowed a salaries of P600,000 and the remaining profit is divided in the ratio
of 1:4
Income Summary 800,000
Ciara, Capital 640,000
Dolly, Capital 160,000

Division of profit
Ciara Dolly Total5
Salaries P600,000 P600,000

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Remainder- 1:4
P200,000 x 1/5 P 40,000
P200,000 x 4/5 160,000 200,000
Total P640,000 P160,000 P800,000

Case 7- Dolly, the managing partner, is allowed a bonus of 20% of profit BEFORE bonus and
income tax and the remainder is divided in the ratio of beginning capital.
Using the income tax rate of 30%, the partnership income before income tax is P1,142,857, that
is, net profit of P800,000 divided by 70%.

Income Summary 800,000

Ciara, Capital 339,769
Dolly, Capital 460,321

Division of profit
Ciara Dolly Total
Bonus(1,142,857x20%) P228,571 P228,571
Remainder:
P571,429 x 2,200/3,700 P339,769
P571,429 x 1,500/3,700 231,660 571,429
Total P339,769 P460,231 P800,000

Case 8- The partners are allowed P5,000 and P10,000 weekly salaries, respectively, 10%
interest on average capital, and the remainder is divided in the ratio of 2:3.
Income Summary 800,000
Ciara, Capital 339,769
Dolly, Capital 460,231

Division of profit Ciara Dolly Total

Salaries to partners
P 5,000 x 52weeks 260,000
P10,000 x 52weeks P520,000 P780,000
Interest on average capital
P2,412,500 x10% 241,250
P1,520,833.33 x 10% 152,083 393,333
Remainder – (P373,333.33)
(P373,333.33) x 2/5 ( 149,333)
(P373,333.33) x 3/5 (224,000) (373,333)
Total P 351,917 P448,083 P800,000
The sum of the salary allowance and interest allowed on the average capital of the
partners exceeded the profit of P800,000 resulting in a negative remainder (loss or deficit).
Such loss is distributed as provided in the profit and loss sharing agreement.60

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Case 9- Assume the same agreement as in Case 8 except that instead of a profit, the
partnership has incurred a loss of P100,000. The allowance for salaries and interest will still be
provided, thereby resulting in a total loss to be divided as agreed.
Dolly, Capital 109,750
Ciara, Capital 9,750
Income Summary 100,000
Division of profit
Ciara Dolly Total
Salaries to partners
P 5,000 x 52 P260,000
P10,000 x 52 P520,000 P780,000
Interest on average capital
P2,412,500 x10% 241,250
P1,520,833.33 x 10% 152,083 393,333
Remainder–(P1,273,333)
(P1,273,333) x 2/5 ( 509,333)
(P1,273,333) x 3/5 (764,000) (1,273,333)
Total (P 8,083) (P 91,917) (P100,000)
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.
The interests of the partners may not be apparent when technical accounting terms are used;
so, the partnership agreement should be precise in specifying measurement procedures to be
used in determining the amount of a bonus.
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 profit after deducting bonus but before deducting income tax.
B = .20 x (P P1,142,857– B)
B = P228,571 - .20B
B + .20B = P228,571
B = P228,571 / 1.20
B = P190,475.83

2. Bonus is based on profit before deducting bonus but after deducting income tax
B = .20 (P1,142,857 – T)
T = .30 x P1,142,857
= P342,85761

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Substituting for T in the first equation and solving for B
B = .20 x (P1,142,857 – P342,857)
B = .20 x P800,000
B = P160,000

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

B = .20 (P1,142,857 – B-T)
T = .30 x P P1,142,857
= P342,857
Substituting for T in the first equation and solving for B
B = .20 x (P1,142,857 – B – P342,857)
B = .20 (P800,000 – B)
B = P160,000 - .20 B
B + .20B = P160,000
B = P160,000 / 1.20
B = P133,333
The partnership form of business allows a wide selection of profit distribution ratios to meet the
individual desires of the partners. Ratios for profit distributions may be based on the percentage
of total partnership capital, time and effort invested in the partnership, or a variety of other
factors. Some partnerships, however, have a profit sharing ratio that is different from their loss
sharing ratio.

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