CHAPTER 2

Partnership Operations
The usual types of accounting problems for
partnership operations are classified as follows:

1. Determination of the proper distribution of

partnership profits and losses among the
partners.
2. Preparation of financial statements for the
partnership, such as balance sheet, income
statement, statement of partners capitals,
and the cash flows.
3. Changes in the profit and loss ratio
4. Correction of net income (loss) of prior
years.
Division of
Profits
and Losses
 The PARTNERSHIP LAW provides
that profits and losses of the
partnership are to be divided in
accordance with the partners
agreement.

If no agreement is made between

the partners, profit and losses are to
be divided according to their
original CAPITAL CONTRIBUTIONS.
*The ratio in which partnership profits and losses
are divided.

POSSIBLE METHODS OF DIVIDING NET

INCOME/LOSS :
1. Equally
2. In an unequal or arbitrary ratio
3. In the ratio of partners capital account
balances on a particular date, or in the ratio
of average capital account balances during
the year.
4. Allowing interest on partners capital
account balances and dividing the
remaining net income or loss in a specified
ratio.
5. Allowing interest on partners and dividing
the remaining net income or loss in a
specified ratio.
6. Bonus to managing partner based on net
income.

The amount and quality of managerial services rendered

and capital invested are also important factors to be
considered in determining profit sharing agreement.
Illustration
of
Profit
Distribution
 Assume that on January 1, 2016, Siy
and Tiu formed a partnership with an
investment of P30,000 by Siy and
P60,000 by Tiu. On December 31, 2016,
after closing all income and expense
accounts, the Income Summary
accounts shows a credit balance of
P60,000, representing the profit for the
year 2016. Changes in the capital
accounts during 2016 are summarized
as follows:
 SIY TIU
Capital balances, January 1, 2016 P40,000 P60,000
Additional investments, March 1 20,000 50,000
Additional investments, August 1 20,000 40,000
Withdrawal, October 1 (20,000) -
Withdrawal, November 1 (50,000)
CAPITAL BALANCES, December P60,000 P100,000
31, 2016
 Division of Profits and Loss Equally
On December 31, 2016, the net income of P60,000
is transferred from the Income Summary account
to the partners capital account by the following
closing entry:
Income summary 60,000
Siy capital 30,000
Tiu capital 30,000
To record division of net income for 2016

* this agreement is common in

practice because of its simplicity
 If the business operations resulted to a loss of
P10,000 during the year, the Income Summary
account would show a debit balance.

Siy capital 5,000

Tiu capital 5,000
Income Summary 10,000
To record division of net loss for 2016

* the loss is transferred to the

partners capital accounts
 Division of Profits and Loss in an
Arbitrary (unequal) Ratio

Assume that Siy and Tiu agreed to divide

profits and losses in the ratio of
60% to Siy and 40% to Tiu. The
agreement that Siy should receive 60%
of the net income would cause Siy to
shoulder a larger share of the net loss if
the partnership operated unprofitable.
 Closing entry to divide the net income of P60,000
to individual partners capital accounts for 2016
follows:

Income summary 60,000

Siy capital 36,000
Tiu capital 24,000
To record division of profit computed a s follows:
Siy: 60% x P60,000 = P36,000
Tiu: 40% X P60,000 = 24,00
TOTAL P60,000
Division of Profits and Loss in the Ratio
of Partners Capital Account Balances

If the partners capital is considered in

allocating partnership income, the agreement
should specify whether the ratio is based on
the:
1) original capital contributions
2) beginning capital balances
3) ending capital balances
4) average capital balances
 (1) Ratio of Original Capital
Contributions

Siy: P60,000 X P30,000 / 90,000 = P20,000

Tiu: P60,000 x P60,000 / 90,000 = P40,000

*30+60 = 90

Income summary
Income Summary 60,000
60,000
Siy capital
Siy capital 20,000 20,000
Tiu capital
Tiu capital 40,000 40,000
 (2) Ratio of Beginning Capital Balances
Assuming that the net income is divided in the
ratio of capital balances at the beginning of
the year. Net income of P60,000 is divided as
follows:

* 40+60=100
Income summary 60,000
Siy capital 24,000
Tiu capital 36,000
 (3) Ratio of Ending Capital Balances
Assuming that profit or loss is to be divided in
the ratio of capital balances at the end of the
year. Net income of P60,000 is divided as
follows:
Siy: P60,000 x P60,000 / P160,000 = P22,500
Tiu: P60,000 x P100,000 / P160,000 = P37,500
* 60+100=160
Income summary 60,000
Siy capital 22,500
Tiu capital 37,500
Division of net income on the basis of (1)
original capital investments (2) beginning
capital account balances (3) ending
capital account balances may be
unreasonable if there are material
changes in capital accts during the year.

Use of (4)average capital balances is

preferable because it reflects the capital
actually available for use by the partnership
during the year.
(4) Ratio of Average Capital Balances

Any additional withdrawals or investments are

entered directly to the partners capital
accounts should be considered in the
computation of the average capital ratio

The average capital balances for year can be

computed using two methods :
a) The Simple Average Method
b) Peso-Month/Peso-Day Method
 * Beginning and ending capital of the partners
Referring to the illustration 2-1.
The average capitals of Siy and Tiu using this method are
computed first as follows:

Siy: (P40,000 + P 60,000) / 2 = P50,000

Tiu: (P60,000 + P100,000) /2 = P80,000
TOTAL: P130,000

The net income can now be divided as follows:

Siy: P60,000 x P50,000 / P130,000 = P23,077
Tiu: P60,000 x P80,000 / P130,000 = P36,923
 The partnership contract should state
whether capital account balances are to be
computed to the nearest month or to the
nearest day.
A common practice is :
(a) to treat withdrawals and investments
made during the first half of the month as if
they were made on the first day.
(b) to treat withdrawals and investments
during the latter half of the month as if they
were made on the first day of the following
month.
PARTNER DATE INVESTMENT CAPITAL FRACTION AVERAGE
S(withdrawa ACOUNT OF THE CAPITAL
ls) BALANCE YEAR ACCOUNT
BALANCES
Siy January 1 P40,000 P40,000 2/12 P6,667

March 1 20,000 60,000 5/12 25,000

August 1 20,000 80,000 2/12 13,333

October 1 (20,000) 60,000 3/12 15,000

P60,000

Tiu January 1 P60,000 P60,000 2/12 P10,000

March 1 50,000 110,000 5/12 45,833

August 1 40,000 150,000 3/12 37,500

November 1 50,000 100,000 2/12 16,667

P110,000

TOTAL AVERAGE CAPITAL ACCOUNT BALANCES P170,00

The net income of P60,000 on December 31, 2016
can now be divided as follows:

Siy: P60,000 x P60,000 / P170,000 = P21,177

Tiu: P60,000 x P110,000 / P170,000 = P38,823

If the partnership agreement of Siy and Tiu specifies

that income is to be divided based on partners capital
balances, but fails to specify how capital balances are
to be computed, the AVERAGE CAPITAL BALANCES
should be used if it can be computed. If not, the
ORIGINAL CAPITAL BALANCES should be used.
 Interest Allowed on Partners Capital
with Remaining Profit or Loss Divided in
an Agreed Ratio.
.
Using interest allowances on partners
capital account in order to achieve a
reasonable profit distribution has no
effect on the computation of the net
income or loss of the partnership.

Interest on partners capital accounts is

not an expense of the partnership.
 Illustration of Allocating Net Profit
*Assume that the partnership agreement allows interest on
partners average capital account balances at 12% with any
remaining net income or loss to be divided equally. The net
income of P60,000 is divided as follows:
Illustration 2-3
Schedule of Profit Distribution
Siy Tiu Total
Interest on average capital:

Siy: P60,000 x 12% P7,200 P7,200

Tiu: P110,000 x 12% P13,200 13,200

Remainder (P60,000- 19,800 19,800 39,600

P20,400) equally
TOTALS P27,000 P33,000 P60,000
 The journal entry to close the Income Summary
account on December 31, 2016 is :

Income summary 60,000

Siy capital 27,000
Tiu capital 33,000
To record division of net income.
 Illustration of Allocating Net Loss
*Assume that the partnership operation results at a loss of
P10,000. On the following schedule of loss distribution,
the net loss of P10,000 is increased by the allowance for
interest of P20,400 to determine the remainder of
P30,400 which is then divided equally.
Illustration 2-4
Schedule of Profit Distribution
Siy Tiu Total
Interest on average capital P 7,200 P 13,200 P20,400
account balances
Remainder, equally (15,200) (15,200) (30,400)

TOTALS P(8,000) P(2,000) P(10,000)

 The journal entry to close the Income
Summary account on December 31, 2016 is :

Siy capital 8,000

Tiu capital 2,000
Income summary 10,000
To record division of net loss.
 In some cases, agreement allowing interest on
partners capital account balances may result to a net
increase in one partners capital account even though
operations for the year resulted to a loss.

To illustrate, assume the same conditions as in the

preceding examples except that the net loss for the
year is P1,000.
Illustration 2-5
Schedule of Profit Distribution
Siy Tiu Total

Interest on average capital account P 7,200 P 13,200 P20,400

balances
Remainder, (20,400+1,000), equally (10,700) (10,700) (21,400)

TOTALS P(3,500) P 2,500 P(1,000)

 Partner Tiu contributed substantially more
capital than partner Siy; the capital was
used in the partnership operations, therefore
the fact that a loss was incurred is not a
reason to deny recognition of Tius greater
capital contribution.

The closing entry on December 31, 2016:

Siy capital 3,500
Tiu capital 2,500
Income summary 1,000
To record division of net loss.
 Salary
and
Bonus
Allowances
Since profits and losses may fluctuate from
year to year, a fair profit and loss sharing
ratio in one year may produce an unfair
division in another year.

The best way to provide for these

differences is to allow salaries to a partner
who devotes time to the partnership
business.

Another variation in P/L sharing agreement is

to provide a bonus to the managing partner
to encourage profit maximization.
 Salary Allowance to Partners with
remaining net profit or loss divided in an
Agreed Ratio.

Partner salary allowances like

interest allowances on capital account
balances are not expenses in the
determination of partnership net income.

They are a means of achieving a fair

division of income based on the time
and talents devoted to partnership
business.
 *Assume that the partnership agreement
provides for an annual salary of P30,000 to Siy
and P20,000 to Tiu, with resultant net income
or loss to be divided equally. The salaries are
paid monthly during the year. The net income
of P60,000 for 2016 is divided as follows:
Illustration 2-6
Schedule of Profit Distribution
Siy Tiu Total

Salaries P30,000 P20,000 P50,000

Remainder(P60,000-P50,000), 5,000 5,000 10,000

equally
TOTALS P35,000 P25,000 P60,000
The following journal entries are required for the
foregoing:
Siy drawing (P30,000/12) 2,500
Tiu drawing (P20,000/12) 1,667
Cash 4,167
To record salary allowances to partners.

End of Year Closing Journal Entries:

(1) Income Summary 60,000
Siy capital 35,000
Tiu capital 25,000
To record division of net income for 2016.

(2) Siy capital 30,000

Tiu capital 20,000
Siy drawing 30,000
Tiu drawing 20,000
 *Assume that on December 31, 2016 Siy
and Tiu Partnership has a net loss of
P20,000 before salary allowances to
partners.
Illustration 2-7
Schedule of Loss Distribution
Siy Tiu Total

Salaries P30,000 P20,000 P50,000

Remainder(P50,000=P20,000), (35,000) (35,000) (70,000)

equally
TOTALS P(5,000) P(15,000) P(20,000)
 The entry to record the division of loss on
December 31, 2013 is:
(2) Siy capital 5,000
Tiu capital 15,000
Income summary 20,000
To record division of loss for 2016.

Partners may agree to allow salaries on a pro-rata basis if

earnings are lower than the total salaries.
Example:
If a partnership agreement provides that salaries are allowed
only to the extent of income earned and the agreement also
provides for salaries of P24,000 to Allan and P36,000 to
Boom, a profit of P30,000 is divided as:

Siy: (P24,000/P60,000) x P30,000 = P12,000

Tiu: (P36,000/P60,000) x P30,000 = P18,000
Bonus to Managing Partner
Based on Net Income
(1)Net income before allowances for
salaries, interest and bonus.
(2)Net income before allowances for
salaries and interest but after deduction
the bonus.
(3)Net income after allowances for salaries
and interest but before bonus.
(4)Net income allowances, interest and
bonus.
*Assume that the partnership of Siy and Tiu has a net
income of P190,200 before salaries, interest and bonus
to partners. The partnership contract provides for the
following:
a) Salaries to Siy and Tiu, P30,000 each
b) Interest on capital account balances:
Siy P7,000
Tiu P3,200
c) Bonus to Siy, 20% of net income.
d) Remaining profit or loss after salaries, interest and
bonus, equally.

THE SHARE OF THE PARTNERS IN THE NET INCOME

OF P190,200 USING DIFFERENT BASIS OF THE
BONUS AS COMPUTED AS FOLLOWS:
 (1) Net income before allowances for salaries,
interest and bonus.
Net income before salaries, P190,200
interest and bonus
Bonus percentage 20%
Bonus P 38,040
*under this method, bonus is not treated as expense but a
as a tool of computing the profit share of the partners.
Illustration 2-8 SCHEDULE OF PROFIT DISTRIBUTION
*Schedule of Loss Distribution Siy Tiu TOTAL

Salary allowances P30,000 P30,000 P60,000

Interest allowances 7,000 3,200 10,200
Bonus to Siy 38,040 38,040
Remainder, equally 40,980 40,980 81,960
TOTALS P116,000 P74,180 P190,200
 (2) Net income before allowances for salaries
and interest, but after deduction of the bonus.
Bonus + income after bonus = P190,200
Let X = income after bonus
0.20X = bonus
Then 1.20X = P190,200 income before bonus
X = P190,200 / 1.20
X =P158,500
.20X = P31,700

Alternative computation for bonus:

Net income before salaries, interest and bonus P190,200 = 20%
Net income after bonus ( P190,200/120%) 158,500 = 100%
BONUS P 31,700 = 20%
*under this method, for purposes of bonus computation, the bonus to Siy
is treated as an expense.
 Illustration 2-9 SCHEDULE OF
PROFIT DISTRIBUTION

Siy Tiu TOTAL

Salary allowances P30,000 P30,000 P60,000

Interest allowances 7,000 3,200 10,200

Bonus to Siy 31,700 -- 31,700

Remainder, equally 44,150 44,150 88,300

(190,200-P101,900)
TOTALs P112,850 P77,350 P190,200
 (3) Net income after allowances for salaries and
interest, but before bonus.
Net income before salaries, interest and bonus P190,200
Less: Salaries P60,000
Interest 10,200 70,200
Net income before bonus P120,000
Bonus percentage 20%
BONUS P24,000
Illustration 2-10 SCHEDULE OF PROFIT DISTRIBUTION
Siy Tiu TOTAL

Salary allowances P30,000 P30,000 P60,000

Interest allowances 7,000 3,200 10,200

Bonus to Siy 24,000 24,000

Remainder, equally 48,000 48,000 96,000

TOTALs P109,200 P81,200 P190,200

 (4) Net income after allowances for salaries and
interest and bonus.
Let X = bonus
X = 20% (190,200-P60,000-P10,200-X)
X = P38,040-P12,000 P2,040 - .20X
1.20X = P24,000
X =P20,000
Alternative computation for bonus:
Net income before salaries, interest and bonus P190,200
Less: Salaries P60,000
Interest 10,200 70,200
Net income before bonus P120,000=120%
Net income after bonus 100,000=100%
BONUS P 20,000=20%
 Illustration 2-11 SCHEDULE OF
PROFIT DISTRIBUTION

Siy Tiu TOTAL

Salary allowances P30,000 P30,000 P60,000

Interest allowances 7,000 3,200 10,200

Bonus to Siy 20,000 -- 20,000

Remainder, equally 50,000 50,000 100,000

(190,200-P90,200)
TOTALs P107,000 P83,200 P190,200

*when there is a net loss, the bonus provision is disregarded

Financial Statements
For a Partnership
 *Statement of Comprehensive Income
Illustration 2-12
SIY AND TIU PARTNERSHIP
STATEMENT OF COMPREHENSIVE INCOME
YEAR ENDED DECEMBER 31,2016

Sales P2,000,000
Cost of sales 1,600,000
GROSS PROFIT 400,000
Operating expenses 209,800
COMPREHENSIVE INCOME P 190,000
Distribution of net income
Siy P107,000
Tiu 83,200
TOTAL P190,200
 *Statement of Changes in Partners Equity
Illustration 2-13
SIY AND TIUPARTNERSHIP
STATEMENT OF CHANGES IN PARTNERS EQUITY
YEAR ENDED DECEMBER 31,2016

Siy Tiu TOTAL

Capital balances, Jan 1 P40,000 P60,000 P100,000

Additional investments 40,000 90,000 130,000

Withdrawals (20,000) (50,000) (70,000)

Balances before net income and P60,000 P100,000 P160,000

drawings
Comprehensive income(loss) 107,000 83,200 190,200

Drawings (30,000) (20,000) (50,000)

Capital Balances, Dec 31 P137,000 P163,200 P300,200

Illustration 2-14
SIY AND TIU PARTNERSHIP
STATEMENT OF FINANCIAL POSITION
DECEMBER 31,2016
ASSETS
Current assets
Cash P 62,000
A/R (net) 74,000
Inventories 90,000
Non-current Assets
Properties and Equipment (net) 154,200
TOTAL assets P380,200

LIABILITIES AND PARTNERS EQUITY

Current liabilities
A/P P 60,000
Loans payable 20,000
TOTAL liabilities P 80,000

Partners Equity:
Siy capital P137,000
Tiu capital 163,200 300,200
TOTAL LIABILITIES AND PARTERS CAPITAL P380,200
 *Statement of Cash Flow
Cash flows from operating activities:
Net income P190,200
Adjustments to reconcile net income to net cash provided
By operating activities:
Depreciation 60,000
Changes in operating assets and liabilities
Decrease (increase) in accounts receivable (74,000)
Decrease (increase) in inventories (90,000)
Increase (decrease) in accounts payable 60,000
Increase (decrease) in loans payable 20,000
Net cash provided by operating activities P166,200
Cash flow from investing activities:
Acquisition of property and equipment (214,200)
Cash flow from financing activities:
Partners investments P230,000
Partners withdrawals (70,000)
Partners drawings (50,000)
Net cash provided by financing activities 110,000
Net increase in cash 62,000
Cash at beginning of year -
Cash at end of year P 62,000
CHANGES IN PROFIT AND
LOSS RATIO
 Partners may agree to change their profit and loss
ratio. When changes occur, several problems will be
encountered in the determination of partners
interest:
1. There may be a difference between the book value
and the fair value of tangible assets.
2. The partnership might have intangibles such as
goodwill that are not recorded in the books but
which must be considered in determining the fair
value of the partners interest.
3. The partnership might have keep its books on a
cash basis, and as a result there may be
unrecorded assets and liabilities.
 Illustration.
Assume that Ben and Cob, sharing profits and losses
10% and 90%, respectively, decided to change their
ratio to 25% to Ben and 75% to Cob. Assume also that
on the date of the change, the partnership held land
that was carried at a cost of P50,000 but had a fair
value of P350,000.
Two approaches that can be used for a fair valuation of the
partners interest:

Land 300,000
Ben capital 30,000
Cob capital 270,000
To record the increase in the Land acct and to credit the respective
partners capital acct using the old profit and loss ratio.
If no adjustments are made on the date of the change, the entry would be:

Ben capital 45,000

Cob capital 45,000c

To credit Cob with 15% (90%-75%) of P300,000 for his share

increase in value of the Land acct and to charge Bens capital
account accordingly.

Assuming that the Land was later sold for P400,00. The gain
would be divided as :
First approach:
Ben: P50,000 x 25% P12,500
Cob: P50,000 x 75% 37,500
TOTAL P50,000
 Second approach:
Ben Cob TOTAL
Portion of gain P30,000 P270,000 P300,000
developed prior to
change in Ratio,
P300,000(P350,000-
P50,000), Divided, 10:90
Portion of gain 12,500 37,500 50,000
developed subsequently,
P50,000(P400,000-
P350,000), Divided,
25:75
TOTALS P42,500 P307,500 P350,000
Correction of Partnership
Net Income of Prior Period
Examples of errors: error in computing depreciation, error
in inventory valuation, and omission of accrued expenses.

When these errors are discovered,

the partners capital accounts should be adjusted.
The ff. accounting procedures may be used:
1. Determine the correct net profit of the prior period.
2. Compute the proper share of each partner using the
profit and loss ratio in the year which the error occurred.
3. Compute the difference between the share in profit that
each partner actually received and the share each
would have receive from no.2
4. Adjust the partners capital accounts by the amount in
No.3
Illustration.
Assume that in 2015, the reported net income of
Dan and Eve was P100,000 and that the partners
divide profits and losses, equally. In the year 2016,
they changed the ratio to 60% for Dan and 40% for
Eve. During 2016, the ff. errors in computing the
2015 net income were discovered:
Using the procedures, the amount of adjustment to the partners
capital account is computed as:
1. Net income per books, 2015 P100,000
Adjustments:
Understatement of depreciation (20,000)
Omission of prepaid expenses 15,000
Omission of accrued expenses (5,000) (10,000)
Corrected net income, 2015 P 90,000
2. The required adjustment to partners capital accounts can now
be determined as :
Dan Eve TOTAL

2015 net income before P50,000 P50,000 P100,000

corrections
2015 corrected net income 45,000 45,000 90,000

3. Required reduction to P 5,000 P 5,000 P 10,000

capital accounts
 4. The entry to adjust the partners capital
accounts on December 31, 2016 is therefore:

Dan capital 5,000

Eve capital 5,000
Prepaid expenses 15,000
Accrued expenses 5,000
Accumulated depreciation 20,000

To adjust partners capital accounts for

errors discovered in computing net income
of 2015