Chapter 18: Partnership Operations

 In measuring partnership profit for a period, expenses should be scrutinized to make sure that partner’s
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.
 The formula used to divide profits and losses is determined through negotiation among the partners.
 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. In the absence of an agreement, the share in profits shall be in proportion to
what they have contributed, but the industrial partner shall receive such share as may be just and equitable
under the circumstances.
 In as much as the law does not clearly specify the capital balance to be applied, it is presumed to be the
original capital. In its absence, such original capital should be the beginning capital.
 Logic dictates that profit and loss should be established at the time of formation due to some of the
following reasons:
a. Subsequent adjustments in assets and liabilities
b. Admission of a new partner
c. Retirement or withdrawal of a partner
d. Liquidation of partnership

Profit and loss sharing formula may include one or more of the following techniques:
A. Equally
o most commonly used because of its simplicity
o may be proper when the capital or service contribution of the partners are considered to be the same

B. Arbitrary ratio
o An infrequently used variation specifies one ratio for profits and another for losses

C. In the ratio of the partner’s capital account balances and dividing the balance on agreed ratio
o Each partner must maintain a specified capital balance that is correlated to the level of responsibility
assumed in the partnership
o Most likely found in limited partnerships
a. Original capital- reference to be made to the amounts originally invested by the partners
b. Beginning capital- additional investments during the period are discouraged because the partners
making such investments are not compensated until a later period
c. Ending capital- year-end investments are encouraged, but no incentive exists for a partner to make
any investments before year-end
d. Average capital- must have provided the fairest basis because it reflects the capital actually
available for use by the partnership during the year
- Should also state the amounts of drawings each partner may make without affecting the capital
account; any additional withdrawal or investments are entered directly on partner’s capital
accounts and influence the computation of average capital ratio
- Problem is on what withdrawal or drawing accounts are to be considered to reduce capital;
addressed through the following guidelines:
1. An agreement should clearly indicate what withdrawals or drawings accounts are to be
recognized
2. An agreement may state that only withdrawals above a certain limit are to be viewed as
offsets (reductions) against capital balances
3. Temporary drawings are not considered, but permanent withdrawals are recognized.
- Average capital balances may be computed through:
1. Simple average- fails to consider the periods of time the changes in capital take place
2. Weighted average- 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)
*For the 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.

D. Interest on partner’s capital accounts and dividing the balance on agreed ratio
o Purpose is to give recognition to differences on capital contribution by partners
o Recognizes the contribution of the partner’s capital contribution to the partnership’s profit-generating-
capacity
o Use is appropriate if the business is capital intensive
o Inappropriate to charge as interest expense because they are not expenses of the partnership
o When the partnership leases property from a lessor who is also a partner, the partnership recognizes
rent expense.
o If partnership contract provides for allowing interest on capital accounts, this provision must be
enforced regardless of whether operations are profitable or unprofitable. Omission is only justifiable if
the partnership contracts contain a specific provision requiring such omission.
o 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.
o When partnership agreement provides without qualification that the interest is to be allowed on capital,
interest must be allowed even though the operations have resulted in net income that are less than the
allowable interest or loss.
o Interest on loans from partners is recognized as expense and as a factor in the measurement of net
income/loss of the partnership. Interest earned is also recognized as revenue.
o Residual income- income to be divided after deducting the provisions for interest on capital

E. Salaries to partners and dividing the balance on agreed ratio

o A partner who devotes time to the partnership while the other partners work elsewhere may receive a
salary allowance. The Philippine partnership law does not provide any provision for remuneration of
services, so it is up to the partners to agree on what is just and fair compensation.
o Salary allowances are not considered as part of the ordinary wages to employees, following the
proprietary theory which views the partners as owners of the partnership. However, if these allowances
were included – the effect is still the same. Although, the proper treatment is as part of the distribution
of net income.
o The purpose of salary allowances are means of achieving a fair division of profit among partners based
on the time and talents devoted to the partnership. These salaries are often included as part of the
profit distribution plan.
o When an agreement provides for salaries without qualification, salary allocations must be made even
though profit is inadequate to cover salaries or even when there is a loss.

F. Bonus to partners and dividing the balance on agreed ratio

o Bonuses are sometimes used as means of providing additional compensation to partners who have
provided services to the partnership. It is also a distribution of profit, not to be charged as expense.
o In the absence of any agreed basis, bonus is computed on the basis of partnership net income.
o 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.
o As long as the basis of computation for bonus will be a positive amount, the resulting bonus should
always be allocated regardless of the availability of the residual amount.
o When a partnership operates at a loss, the bonus provision is disregarded.

Bonus before deduction of bonus – B = % of (NI)

Bonus after deduction of bonus – B = % of (NI – B)
Bonus after bonus and income tax – B = % (NI – B – T)

G. Interest on capital account balance, salaries, and bonus to partners and dividing the balance on agreed
ratio
o If the partnership fails to provide provisions in cases where net income is insufficient for interest, salary,
and bonus allocations, the established practice is to allocate these amounts as if sufficient income has
been earned. The excess of the amount with the net income is allocated to the individual partners in
their agreed ratio for allocating residual income.
o It is possible to record salaries and interest as part of expense items rather than as distribution or
allocation of net income.

Correction of Partnership Prior Period Net Income

 Problems in the allocation of P/L can result if (1) errors are discovered that occurred in specific prior years
or (2) the partners have altered the P/L agreement since the period in which the error occurred.
 Corrections are allocated to the individual partners’ capital accounts. It should be based on the P/L
agreement in effect during the period of the error.
 Use the old P/L ratio for fixed assets which are revalued and have existed before the change in allocation.
 When the P/L sharing formulas 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:
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

Special Profit Allocation Methods

A. On the basis of partnership “units” – additional units are assigned by a partnership compensation
committee for obtaining new clients or for providing the firm with specific areas of industrial expertise

B. On performance methods – gives some weight to the specific performance of each partner to provide
incentives to perform well

1. Chargeable hours- total number of hours the partner incurred on client-related assignments
2. Total billings- total amount billed to clients for work performed and supervised by a partner constitutes
total billings
3. Write-offs- consist of amount of uncollectible billings
4. Promotional and civic activities- time devoted to developing future business and enhancing the
partnership name in the community
5. Profits in excess of specified level

Statement of Changes in Partners’ Capital Accounts

 Capital withdrawals and personal withdrawals are separated. The former appears on the ending capital
before net income, while the latter after distribution of net income.
 This is also accompanied with a profit distribution table or a schedule on the allocation of net income.