Ateneo de Naga University

College of Business and Accountancy

Accountancy Department

Partnership Accounting Concepts and Problems

Partnership Operations

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 loss 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.

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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 capital ratio to be used in
distributing profits or losses in the operation of the partnership. The partnership
contract should state whether weighted capital balances are to be computed to the nearest
day (peso-day approach) or to the nearest month (peso-month 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 partners’ 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 an 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 either before or after the bonus. When silent, 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.

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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 follows:

X, capital Y, capital
1/1/2014 P300,000 3/1/2014 P30,000 1/1/2014 P420,000
4/1/2014 60,000 11/1/2014 60,000
12/31/2014 P360,000 12/31/2014 P450,000

X, drawing 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) X and Y agree to allocate net income in the ratio of 3:2.
3) Allocation of net income shall be based upon original capitals.
4) Beginning capital balances are used in allocating partnership profit.
5) Allocation of net income shall be based upon partner’s capital at the end of each year.
6) Allocation of net income shall be based upon simple average capitals for the year.
7) Allocation of net income shall be based upon weighted average capitals for the year
8) 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 balance is to be allocated in the ratio of beginning capital.

Illustrative Problem #2
The net income of A and B Partnership for 2014 amounted to P420,000. A, as the
managing partner, is entitled to bonus.

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 the net income assuming:
a) Bonus is based on net income before bonus, salaries, and interest.
b) Bonus is based on net income after bonus but before salaries and interest.
c) Bonus is based on net income after bonus and salaries but before interest.
d) Bonus is based on net income after bonus, salaries and interest.

2) Compute the bonus of A assuming:

a) Bonus is based on net income after salaries but before bonus and interest.
b) Bonus is based on net income after interest but before bonus and salaries.
c) Bonus is based on net income before bonus but after income tax (tax rate is 35%).
d) Bonus is based on net income, that is after bonus and income tax.

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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 Y, capital
1/1/2015 P360,000 3/1/2015 P36,000 1/1/2015 P504,000
4/1/2015 72,000 11/1/2015 72,000
12/31/2015 P432,000 12/31/2015 P540,000

X, drawing Y, drawing
1/1-12/31 P43,200 1/1–12/31 P136,800

12/31/2015 P43,200 12/31/2015 P136,800

Required: Prepare journal entries to allocate net income based on:

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.

Required: Determined the amount of bonus, assuming:

a) Bonus of 20 percent of net income before the bonus is deducted (bonus is treated as an
allocation of distribution of net income).
b) Bonus of 20 percent of net 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.

Required: Calculate the amount of bonus to be allocated to Roger.

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?

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 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 on 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

Required: Prepare a schedule to allocate net income, assuming:

a) Bonus is based on net income before bonus, salaries and interest.
b) Bonus is based on net income after bonus but before salaries and interest.
c) Bonus is based on net income after bonus and salaries but before interest.
d) Bonus is based on net income after bonus, salaries and interest.
e) Bonus is based on net income after salaries but before bonus and interest.
f) Bonus is based on net income after interest but before bonus and salaries.
g) Bonus is based on net income before bonus but after income tax (tax rate is 35%)
h) Bonus is based on net 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, Mark, 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 balance.
Drawings in excess of annual salaries will be considered reduction in capital.
Interest is computed at the rate of 10 percent.
 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, Ace, Mark, Mark, Ric, Ric,
capital drawings capital drawings capital drawings
Beginning
balance P 75,000 P 0 P125,000 P 0 P 40,000 P 0
February 1 15,000 25,000 30,000
March 31 10,000 5,000 15,000
June 1 10,000
June 30 10,000 5,000 15,000
August 1
September 30 10,000 15,000
Ending
P 85,000 P 45,000 P125,000 P 35,000 P 70,000 P 45,000
balance

Required: Determine how the annual net income of P200,000 (including a gain on the sale of
equipment of P15,000 should be allocated among partners. Annual sales revenue was P1,100,000.

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