CHAPTER 1 SINAN A PARTNERSHIP FORMATION AND OPERATI ONS INTRODUCTION ~ ¢ 19 This chapter presumes an understanding, of the basic. concepts and standards of. financial accounting, especially those pertaining, to the, measurement of assets, liabilities, equity, income and expénses. It also presumes understanding of the basic laws on partnership, i b Two or more individuals having common interest or profession may decide to pool their resources, venture into business and organize a partnership. The partnérship, like any form of business organization, must adhere to the entity concept. It must be viewed as separate and distinct from the owners; hence, its transactions must be accounted for properly and in accordance with accounting standards in its own set of books. To avoid disagreement, there should be a clear arrangement on how the profit or loss of the partnership must be allocated among the partners. After studying the chapter, the student must be able to: 1. define a partnership and explain its characteristics; . explain the advantages and disadvantages of organizing a partnership as compared to a corporation; rf 7 . differentiate the different types of partnerships and partners; . recognize and measure initial investment of partners; . recognize and measure partnership income and expenses | of . record distribution of partnership profit or loss among Partners using the various of profit and loss distribution methods - 7. prepare a statement of changes in partners” equity Nowy DEFINITION ha ls to poles azaloChapter 1 - Partnership Formation and Operations CHARACTERISTICS OF A PARTNERSHIP 2. Co-ownership of contributed assets. Assets contributed to the partnership | 0-01 i i f its separate legal personality. is of the partnership by virtue of its s eson i ame ae Partnerships, except general professional partnerships (ie. those ramaioed for the exercise of professions like CPAs, lawyers, engineers, etc.), are subject to income tax at the rate of 30% of profit, Limited life. A partnership may be dissolved at any time by action of the . partners or by operations of law. Chdmiehy , dom, wairgiqua! Jibeapechy Legal entity. A partnership has a legal personality separate and distinct from that of each of the partners. Mutual agency. Any. partner may act as an agent of the partnership in conducting its affairs. Mutual participation in profits. A partner has the right to share in partnership profits. Unlimited liability. The personal assets of any partner may be used to satisfy the creditors’ equities in the partnership if the firm’s assets are not enough to settle the liabilities to outsiders. (Suvi torre ADVANTAGES OF A PARTNERSHIP LL 2. Itis easy and inexpensive to organize compared with a corporation. The unlimited liabilit it y of the partners makes it reliable from the point of view | of the creditors. The combined personal credit of the partners offers b i 0 do ., etter o| obtaining additional capital than does a sole proprietorship. Pas The participation in the business by m a closer supervision of all its activities, lore than one person makes possible for= Partnership Formation and Operations: — Chapter 1 Partnership 7 | DISADVANTAGES OF A PARTNERSHIP The personal liability of a partner for partnership debts. de 1. ‘. investing capital in a partnership, ters many from 2. A partner may be subject to a personal liability for the Wrongful acts or omissions of his associates. 4 It is less stable because it can be easily dissolved. \ : é 4. There is divided authority among the partners. 5. There is a constant likelihood of dissension and disagreement when each of the partners has the same authority in the management of the partnership. 6. There is difficulty in disposing of interest since no formal established marketplace exists for the sale of partnership interest. KINDS OF PARTNERSHIPS 1. As to Activity a. Trading partnership - one whose main activity is the manufacture or the purchase and sale of goods. b. Nontrading partnership ~ one organized for the purpose of rendering services, . ' 2. As to Object a. Universal partnership . 1. Universal partnership of all present property - one in which the partners contribute all the properties which actually belong to each of them, at the time of the constitution of the partnership, to a common fund with the intention of dividing the same among themselves as well as the profits which’ they may acquire therewith. : LanaChapter 1 Partnership Formation and Operations i ises all that il i ill profit - one which comprises al > Ce ee OF, fee industry or work during the e pa : existence of the partnership an or immovable property W the time of the institution of the contrac d the usufruct of movable property hich each of the partners may possess at i ich has for its object determinate ‘things, . icular partnership - one which ; : f bara or fruits, or a specific undertaking or the exercise of a profession or vocation. 3. As to Liability of Partners a. General co-partnership - one consisting of general partners who are liable prorata and sometimes solidarily with their separate property for partnership debts. : i b. Limited partnership - one formed by two or more persons having as members one or more general partners and one or more limited partners, as such are not bound by the obligations of the partnership. The ord "LIMITED" or "LTD." is added to the name of a partnership to inform the public that itis a limited partnership. ” 4. As to Duration a. Partnership at will - one for which no time is specified and is not formed for a particular undertaking or venture and. which may be terminated any time by mutual agreement of the i orot Partners or by the will b. Partnership with a fixed term - one.in which the term or period fc Which the partnership is to exist is agreed upon or one eet a Particular undertaking and upon the expiration of that te oe ‘i completion of the particular undertaking, the partn issolved unless continued by the partners,” it titeChapter I= Partnership Formation anid Operations. 5, As to Representation to Others a. Ordinary partnership - one which actually exists among the partners and also as to third persons. b. Partnership by estoppel - one which in oot is not a partnership but is considered a partnership only in relation este their conduct r omission are /precluded Baan! 6. As to Legality of Existence a. De jure partnership - one which has complied with all the requirements for its establishment. b. De facto partnership - one which has failed to comply with one or more of the legal requirements for its establishment. 7. As to Publicity a. Secret partnership - one wherein the existence of certain persons as partners is not made known to the public by any of the partners. b. Open partnership - one wherein the existence of certain ‘persons as partners is made known to the public by the members of the firm. & CLASSES OF PARTNERS 1. As to Contribution a. Capitalist partner - one who contributes capital i in the form ‘of money or property. race b. Industrial partner - one who contributes industry, labor, talent, skills or service. ©. Capitalist industrial partner = one who contributes money, property:and industry.6 Chapter 1- Partnership Formation and Operations 2, As to Liability a. > 3. As to Management a. General partner - one whose liability to third persons extends, to his enel 2 separate (private) property. jabili i is limited only t - whose liability to third persons is ly to coal tribution into the partnership. {Get ively, the business of the Limited partner - 00 the extent of his capital co1 Managing partner - one who manages acti partnership. Silent partner - one who does not participate in the management of the partnership affairs. 4. Other Classifications a. b. c. ° Liquidating partner - one ‘who takes charge of the winding up of partnership affairs upon dissolution. Nominal partner - one who is not really a partner, not being a party tc the partnership agreement, but is made liable as a partner for tht protection of innocent third persons. ? Ostensible partner, - one who takes active part in the management of thi firm and is known to the public as a partner in the business. Secret partner ~ one who takes active part in the management of th business but whose connection with the partnership is ‘concealed 6 unknown to the public, Dormant partner * one who does not take active part in the managemen of the business and is not known to the public as a partner; he is both silent and a secret partner. ARTICLES OF CO-PARTNERSHIP " A partnership is created by an oral or a written agreement. Since partnerships are required Commissi to be ‘Tegistered with the Office of the Securities and Exchange ‘ons, it is necessary that the agreement be in writing.o Chapter 1- Parmership Formation and Operations : : a In this case, misunderstandings and disputes among the partners relative to the nature and tet 9 .s the following information: The Articles of Co-Partnership contain 1, The name of the partnership; ‘ 2. The names, addresses of the partners, classes of partners stating whether the partner is general or limited partner; 3. The effective date of the contract; ' . 4. — The purpose or purposes and principal office of the business; 5 5. The capital of the partnership, stating the contributions of individual partners, their description and agreed values; 6. The rights and duties of each partner; 7. The manner of dividing profit or loss among the: partners, including, salary allowance and interest on capital; Ik eb aal 8. The conditions under which the partners may withdraw, money or other assets for personal use;, 9. The manner of keeping the books of accounts; 10. The causes for dissolution; and \ 11. The provision for arbitration in settling disputes. Fiesta ACCOUNTING FOR PARTNERSHIPS i PLURALITY OF CAPITAL AND DRAWING Accounts. Accounting for a partnership differs from other forms of business organizations with regard to capital accounts: In a partnership, there Should be as. many capital accounts and as many, drawing accounts as there are partners. The transactions affecting the capital and drawing accounts of each partner are as follows: ; 7 i ()_capiran account (4) | 1. Permanent withdrawal (decrease) | 1. . Original investment by a we of capital Bory Hh Partner het, ae ‘i 2. Share in partnership loss from 2. — Share in partnership profits : Operations ‘lad from operations “{p¥) . Debit balance of. drawing account 3. Additional investment by closed to capital a partner’) 4 tape)Chapter 1- Partnership Forniation and Operations WwW 7. RAWING ACCOUNT _ i a by fi partner 1. Share in partnership Profits from Teint ian | Sie eet Cet » (Temporary withdrawal of capital) i ‘ } ership loss from Devry re in partnership 2 Soe ations (this may be debited directly to capital) Opt : PARTNERSHIP FORMATION Partners may contribute cash, property or industry to the partnership. Asset contributions are debited to the appropriate asset accounts and credited to the capital accounts of the If the asset contributed is market value. When c entry is prepared. ues or, in the ‘ontributions are in the ners’ non-cash investments at their’ ng Recording alg ensures losses on subsequent disposition of the property through use or throug! ii be equitable. Such gains and losses are then correctly divided in the profit and loss ratios provided in the partnership agreement. Illustrative Problem A: Acosta and Beltran agreed to’ form a partnership to be’ known as AB ENTERPRISES. The entries to record the formation of the partnership under three independent assumptions are as follows. Assumption I ~ Cash Contributions. Each partner invested cash'of P250,000 for an equal interest in the partnership. stig to 500,000 8 vet youu 250,000 “e..250,000 . Cash Acosta; Capital Beltran, CapitalChapter 1- Partnership Formation and Operations 9 d Non-cash Contributions. Acosta contriby 2 P130,000 and with agreed value red saat of fing P170,000 with accumulated depreciation ‘Assumption 2 - Cash and No1 P160,000 and inventories costin Beltran contributed equipment, cos! th a f P150,000, for a one-third interest, of P25,000 and agreed value o' Cash 160;000 ‘ Inventories ae Equipment ye anon Acosta, Capital 300,000 150,000 Beltran, Capital issets and Industry. Acosta contributed cash of 000 with Allowance for Uncollectible’ -d at 400,000. Beltran is an industrial Jents to the partnership for a one-third ‘Assumption 3 — Cash, Non-cash A: P100,000; Accounts Receivable of P150, ‘Accounts of P50,000; and Equipment value partner to contribute his special skills and tal interest. Cash 100,000 Accounts Receivable 150,000 Equipment 400,000 ‘Allowance for Uncollectible Accounts 50,000 600,000 Acosta, Capital Beltran is to contribute his services to the partnership for a one-third interest. KEY OBSERVATIONS FROM THE ILLUSTRAT * Since the partnership is an entity separate and distinct from that of each of the partners, the assets/net assets contributed by the partners are recorded in the books of the partnership at their agreed values or fair market values at the time of contribution. * »No‘accumulated depreciation is recorded in the partnership’ books rélative’to “non-cash asset contributions that were'previously depreciated. The agreed value or fair market value of the non-cash asset contributions represent the cost of the plant assets to the partnership and such become the basis ‘for-future depreciation by the partnership.4 Chapter 1- Partnership Formation and Operations | | 10 FORMATION II ‘ole proprietors who In some instances, one or two or all of ‘the partners are former a sitonecr ext vse decide to unite their assets and liabilitie: Mone Dn ont, ership’ may open a new set of bool ¢ sole proprietors. If a new set ee Il be opened for the partnership, entries similar to those presente in’ the Preceding illustration shall be made. However, if the books of one of the sole proprietors are used, the following Procedures shall be followed: ik Reid staherbooksrotisele'proprictor which will be used as partnership ooks, an ) 2. Record the investment of the other partners. Illustrative Problem B: Acosta at ind Beltran, both sole Proprietors, agreed to form a partnership. Account balances per ledger and the respective agreed values upon 1 formation are shown below. ag 1 Acosta \ Beltran | Per Books As ‘Agreed Per Books As Agreed) Cash P 150,000 150,000. P140,000 140,000, Accounts Receivable 140,000 140,000 135,000. 135 000 Allowance for Uncollectible Accounts ( 50,000) ( 40,000) ( 30 000) ¢ 40,000) Inventories 135,000. 137,000 ,000 130,000 Equipment, Cost 300,000 } 150,000 200,000. - 175,000 Accumulated Depreciation ( 60,000)F.. > -( 20,000), ' Accounts Payable ), 100,000. ::100,000 : 150,000 150,000Chapter I~ Partnership Formation and. Operations. Assumption 1 to record the contributions of the pa! To record the contribution of Acosta rtners are as follows: Chdjux The entries @ Cash 150,000 Accounts Receivable Saas Inventories a . 00 Equipment 150,01 ‘Allowance for Uncollectible Accounts 40,000 Accounts Payable 100,000 Acosta, Capital 437,000 (b) Torecord the contribution of Beltran Cash 140,000 Accounts Receivable 135,000 Inventories 130,000 Equipment 175,000 Allowance for Uncollectible Accounts 40,000 ‘Accounts Payable 150,000 390,000 Beltran, Capital Assumption 2 eaberieiedees ta wil by new partn if - ase ate Na Pte eee ee journal entries to recoré squire ri récord the investment of t Beltran are as follows: (a) ledger balances to agreed values Allowance for Uncollectible'Accounts Inventories Accumulated Depreciation Acosta, Capital Equipment The f To record the adjustments on the books of Acosta in order to bring the (dst) 10,000 2,000 60,000 78,000 i 150,000 xo 200 nChapter 1 - Partnership Formation and Operations 2 (b) To record the investment of Beltran... en 140,000 as 35,000 Accounts Receivable : acoud Inventories 175,000 Equipment . 40,000 Allowance for Uncollectible Accounts 150,000 Accounts Payable 390,000 Beltran, Capital one of the When individual set of books are kept by each cae re Partners, entries are made in the separate books of the pai h the capital accounts the recorded values. ‘These adjustments are made through i Alternatively, a Capital Adjustment Account may be used. The balance of this account, after recording all the necessary adjustments, is transferred to the capital account. Entries to close the individual set of books kept by the partners, particularl ers also. made. To The partnership formation b: more sole proprietors may the result of the ac Proprietors. The ya sole proprietor and an in involve the recognition of g quisition by the new part dividual or among two or oodwill. The goodwill is hip of the net assets of the sole to. i . le Or, over, the Under PFRS 3, goodwill acquired ia! Seaee “circumstances fet et antwually, or. more frequently. 44 events or changes ir circumstances indicate that the asset might be impaired, 1 KE Y OBSERVATIONS FROM THE ILLUSTRATIONS * When all the prospective Partners are already in busine i P 3 ly in business as sole Proprietors, they may decide to transfer their assets and liabilities (net assets) to the partnership as their Contributions upon formation of the Partnership, siChapter 1 - Partnership Formation and. | Operations, 13 4 the agreed values or fair market values, * To bring the balances of accounts a id ss 5 nies are revorded pon partnership formation through the capital -ccpounts of the partners. ‘However, a Capital Adjustment Account may be tised;_its balance after all the adjustments in net assets are made is transferred to the capital account. : hip, the entry required in + When a new set of books are opened for the partnership, the new books of the firm is the recording of the investment of the partners at agreed values or fair market values. the separate books of the sole proprietors, which are * Entries to adjust and clos also made. not to be used as partnership books, are CAPITAL SHARE DIFFERENT FROM CAPITAL CONTRIBUTION ns to the partnership, the individual f net asset contributions but also on Prior to recording partners’ initial contributio Genel te capital share ofa partner is proportionate ition. However, in recognition of intangible factors such as a partner’s special expertise, established clientele or necessary business connections, partners ¢ to a division of ci 2 contributions, This will give rise Illustrative Problem C. Acosta and Beltran agreed to divide initial partnership capital equally even though Acosta contributed P500,000. while Beltran contributed P400,000 cash into the partnership, Journal entries to record the investment of the partners under two approaches are as follows: § 1. Full investment approach Cash 900,000... Acosta, Capital Beltran, Capital 0 400000Chapter 1- Partnership Formation and Operations Wa 2, Bonus Approach po ; 900.09 450,000 Cash o: scosta, Capital ited Beltran, Capital INS KEY OBSERVATIONS FROM THE ILLUSTRATIONS i il to his/her not necessarily equal . ital interest of each partner 1s e wie ie Ponca The partners may allocate the sap co or me any ane they desire as long as all of them agree to the allocat recorded accordingly. * A different problem of valuation arises when partners agree cr oa interests that are not aligned with the investments of identifiable assets. gives rise to recognition of bonus on initial investment. LOAN RECEIVABLE AND LOAN PAYABLE. Aside from the contributions, the \partnership may acquire additional financing from its present partners. Any Joan between a partner and the partnership is always accompanied by a f documentation such as a promissory note. Alon om. pévaler ae Loan Payable on the partnership books, similar to any other loan, Unless all partners agree otherwise, the partnership i obligated to pay to the individual partner interest on the loan and sui is reported in the Income Statement of the partnership as an expense, On the other hand, the fertnership may also lend money toa pate In this ca hand, m 0 4 se, the partnership records a eceivable from the partner. Again, unless otherwise agreed by the partners, the’ loan bear. i oan bi and such interest is reported in the Income Statement of the partnership as le. o PARTNERSHIP OPERATIONS Ai , PROTE ost ND DISTRIBUTION OF 3 Accounting for Partnership Operations of any other form of busii n a usiness account is debited to Acc bio. accounts is debited to Ca of merchandise on acco Sperations is essentially the same as accounting for the \ ganization, Sale of merchandise on hand ceclvable and credited to Sales. Collecnen of a a credited to Accounts Receivable. The purchase tecorded by a debit to Purchases and a creditChapter I - Partnership Formation and Operations ints is debited to Accounts Payable and debited to Expenses’ and credited to_ Accounts Payable. Payment of accounts credited to Cash. Payment of expenses 15 Cash. F . Fi ns However, special problems are encountered in accounting for __ partnership operations. These problems include: Closing entries of a partnership Distribution of profits and losses Preparation of a work sheet Preparation of financial statements a, Statement of financial position A b. Income statement and statement of other comprehensive income (or a combined statement of comprehensive income) c. Statement of changes in partners’ equity The procedures for the preparation of closing entries for a partnership are similar to that of a sole proprietorship. First, aK nominal a s with credit (such as Purchases Discount ag lited. Second, rary is del accounts with lances (such | Suite. Third, the balance of the Income Summary account, which represents profit or loss of the partnership, is transferred to either the drawing accounts or capital accounts of the partners. Finally, the balance of the drawing account of each. partner. is transferred to his/her capital account. Beye The balance of the Income Summary account -is. transferre accounts of the partners if the partners’ intention is to. keep the capital account intact for investments and permanent withdrawal of the partners based on th The entry is as follows: Income Summary A, Drawing B, Drawing Profit and loss Sharing ratio.id Uperations ship Formation ane

. AS to industrial [partners ‘ a. Division of profits i In accordance with agreementsz Chapter 1 - Partnership Formation and Operations. - b. Division of lasses 1. Inaccordance with agreement will share in proportion to capacity as a capitalist partner. Sopeacitl - ‘n accordance with the agreement ¢ partners shall share in the satisfying the share of the In general, profits and losses shall be divided i among the partners. In the absence of an agreement, the profits in proportion to their capital contribution after industrial partner on such income. METHODS OF DISTRIBUTING PROFITS BASED ON PARTNERS' AGREEMENT 1. Equally - it is simple to apply but does not give due 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. 2. 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. 3) 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. I 4. Interest on capital - this method recognizes the differences in the capital contributions but does not take into account the time and effort that-a artner may devote in running the firm’s business. P Interest is al ‘agi Il be allowed in proportion to the lowed to partners for the use of invested capital. 5. Salary allowances to partners - this method i Teco; i that a partner may devote in running the: firm’; pace cme and effort F : < i 's/businegs; but into consideration the differences in capital, ‘1 Se it does inot: take ax eonttibutions: 36 i bajaChapter 1 - Partnership Formation and Operations 2 4 is method allows bonus to the managing 6. Bonus to managing partner - this met! i Parner as an incentive It is usually based on net profit, Bonus, therefore, * i the following as the basis: Bonus may be computed using any one of tt s a. Bonus is esed on profit before deducting bonus and income tax. : b. Bonus is based on profit after deducting bonus but before deducting income tax. P c. Bonus is based 6n profit before deducting bonus but after dedu income tax, d. Bonus is based on profit after deducting both bonus and income tax. icting The partnership form of business allows a wide selection of profit distribution Tatios to meet the individual desires of the partners. Ratios for profit distributions may be based on the percentages of total partnership capital, time and effort- invested in the partnership, or a variety of other factors. be distributed in the same manner as the partnership. prof Partnerships. have profit ratios different from loss ratios. Illustrative Problem E: year. Changes in capital The EF Enterprises realized a profit of P240,000 for the accounts of the partners during the year are as follows: h Estrada, Capital Jan. 1 Balance 500,000 Apr. | Additional investment 50,000 / May | Withdrawal 20,000 va s Oct. 1 Additional investment 100,000 ‘ Fajardo, Capital oy Jan.1 Balance Mwenc wy aw Sept. 1 Additional investment Dec. 1 Withdrawal the division of Prot are presented in the Succeeding pages... 4 fit using variouat Chapter 1 - Partnership Formation and Operations Assumption 1 - Profit is divided equally 240,000 Income Summary 120,000 Estrada, Capital, 120,000 Fajardo, Capital P240,000/2 = P120,000 Assumption 2 - Profit is divided in the ratio of 3:2 Income Sutnmary 240,000 4:00 Estrada, Capital 9 6.000 Fajardo, Capital P240,000 x 3/5 = P144,000 P240,000 x 2/5 = P 96,000 Assumption 3 — Profit is divided 45% to Estrada and 55% to Fajardo Income Summary 240,000 Estrada, Capital 108,000 Fajardo, Capital 132,000 P240,000 x 45% = P108,000 P240,000 x 55% = P132,000 (% ( le Assumption 4 — Profit is divided according to beginning capital ratio 7 Income Summary 240,000 Estrada, Capital 150,000 F Fajardo, Capital 90,000 P240,000 x 500,000/800,000 = P150,000 P240,000 x 300,000/800,000 = P 90,000 o get £ FUL Ture are ey rte) Assumption 5 - Profit is divided according to average capital a ae Income Summary 240,000 Estrada, Capital boyy Fajardo, Capital (152,520 240,000 x 549,170/864,170= P152,520 ” 87,480, P240,000 x 315,000/864,170 = P 87,480Chapter 1 - Partnership Formation and Operations 2 Computation of average capital using the peso months method: ital: ae At 31 P500,000°x 3 stous Xt Sova ESoO.con Apr. 1—Apr.30 $50,000 x 1 sea x4 [a 00° Bean May 1—Sept.30 530,000x 5. 2 ¥3) oe. hisspan Oct.1-Dec.31 — 630,000x 3 (oo K3u <2 —_1,890,000 s4iw B6,590,000 i Average capital - P6,590,000/12 ° m5 P_ 549,170 ’ « i Fajardo, Capital: we , Jan. 1 May 31 300,000 x 5 eee June 1-Aug.31 270,000 x3 oon Sept.1—Nov. 30. 370,000 aA 7120000 - Dec.31 360,000 x Dee. | - Dee. 30.000 Average capital ~ P3,780,000/12 P.315,000 Assumptions 1 to 5 provide for the division of profit using a single allocation ‘procedure. However, in some instances, the partnership agreement may provide for 'a combination of several allocation procedures (multiple bases of profit allocation) to be used in the distribution of profit. The following assumptions are used to illustrate various multiple allocatior procedures, Wee Assumption 6 - Each partner is allowed 10% interest on ending capital and th remaining profit is divided equally Income Summary r 240,000 Estrada, Capital one 133,500 Fajardo, Capital 106,500, Estrad , Interest on ending capital: rat Palade oval neal 630,000 x 10% P-63,000 : 4 360,000 x 10% ‘ P 36,000 Remainder ~ equally 4 P:29,000, P141,00072 10, Net Profit = 70,500.” _141,000° | Dine che: UN 723 Chapter 1 = Partnership Formation and Operations , ining profit Assumption 7 — Fajardo is allowed salaries of P 150,000 and the remaining Pp: js divided in the ratio of 4:1 000 Income Summary t 24) 72,000 Estrada, Capital 168,000 Fajardo, Capital . : a Estrada _ Fajardo patty Salaries to Fajardo 2 P150,000 PISO Remainder - 4:1 ho! 90,000 x 4/5 P 72,000 P90,000 x 1/5 18,000 =n Net Profit Poo ©—»«-B68,000 240,000 y Assumption 8 — Fajardo, the managing partner, is allowed a bonus of 20% of profit before bonus and income tax and the remainder divided equally Income Summary 240,000 Estrada, Capital 85,714 Fajardo, Capital 154,286 Income before income tax is P342,857(P240,000/70%) Estrada Fajardo Total Bonus (P342,857 x .20) P 68,572 P 68,572 Remainder - equally 714 _171,428 Net Profit 4 240,000 Other assumptions on the computation of bonus shall be illustrated below using the same data used in Assumption 8. cel osha (a) The bonus is based on profit after deduction for bonus but before. deduction for, income tax B=... .20(P342,857- B), : B P68,572-.20B 4. » ob B+.2B P68,572 1 tikes. . 1.23 POBS72 cer fiat’ schol as B P68,572/1.2 Bf ae SRE PspChapter 1 - Pav rmership Formation and Operations mu fier deducti bonus is based on profit before deduction for ponus but after deduction for | ‘The bonu: a income tax | B= .20(P342,857-T) T= 30% x P342,857 | T= 102,857 and solving for B: Substituting for T in the first equation B= .20(P342,857- P102,857) B= p48,000 i an (©) The bonus is based on income after deduction for bonus B = 20 (342,857 - B-T) “30 (P342,857 - B - P102,857) id income tax A “20 (P240,000 - B) B 48,000 -.20B | B +.20B 48,000 | 1.20B 48,000 | B 48,000/1.2 | B = P40,000 ORDER OF PROFIT SHARING PROVISION Some partnerships specify a profit distribution to be followed to whatever extent possible. Most agreements specify that the entire process is to be completed and lany remainder is to be allocated in the profit and loss ratio, ‘The allocation éf - partnership profit follows the order of the profit sharing agreement in allocating ie bonus, the salary allowances, the interests and the remainder to individu partners. i The bonus is computed on the basis of partnershi rofi . it f “partnership net profit” is Soantin ee eS is generally understood in accounti i may, however, intend for salary and interest allbwanves a dbo’ deducted if determining the base for computing the bonus. In such case, no bonus is allowed if there is insufficient profit after distribution of salaries and interes Assumption 9 — The Partnership P50,000 to Estrada and Fajardo, bonus to managing partner Faja will be divided equally. agreement provides salaries of P100,000 and respectively; 10% interest on ending capital; 20% do if the net profit is sufficient; and the balance bj jue agChapter 1- Partnership Formation and Operations z Income Summary 240,000 Estrada, Capital : 157,000 Fajardo, Capital 83,000 Estrada’ Fajardo ‘Total Interest on ending cap. P 63,000 P 36,000 P 99,000 Salaries 100,000 50,000 ‘150,000 Balance - Equally (4,500) _(_4,500) _(.9,000) Net Profit Pis8s00 P.81,500 240,000 ORDER OF PRIORITY PROVISION + In'some instances, the partners may agree not to use a residual sharing ratio in the event profits did not exceed the total of the salary and interest allowances. In this case, the partners must agree on the priority of the various features. If the partnership agreement gives salary allowances priority over interest on capital balances, then profit would first apply to salaries and the balance would be divided in the ratio of interest allowance and vice-versa. Assumption 10 ~ The partnership agreement provides salaries of P100,000 and P50,000 to Estrada and Fajardo, respectively; 10% interest on ending capital; and the balance will be divided equally. Profit is to be allocated by first: giving priority to interest on invested capital and then on salary allowance. Income Summary 240,000 Estrada, Capital 157,000 Fajardo, Capital 83,000 Estrada Fajardo Total P 63,000 P 36,000 P 99,000 0: 94,000 __47,000_141,000 Net Profit pee P157,000 P_83,000 P240,000 Interes i The order of profit sharing provision generally applies unless the partners agree on the order of priority provision relative to profit distribution, Key OBSERVATIONS FROM THE ILLUSTRATIONS * The profit or loss distribution, as agreed upon by all'the partners, may be as simple as dividing profits evenly among the’ partners or‘based on a ratio unrelated to capital balances or any other operating feature of the partnership. On the other hand, the partnership profit or: loss’ may also be’ divided using multiple bases of allocation which include interests, salaries and bonuses.” ..!- saChapter 1 = Partnership Formation and Operations 26 ana interest on capital balances ibutii ip profit by allowing interes’ c + Distributing Parton of the partners’ investments to the profit generating recognie® the partnership. The interest allowed to partners is proportionate to capaci the period the capital was invested into the business. rtnership agreement may provide for salaries and bonuses because of the pe a to tie partnership of the partners’ services. Partners are owners, semployees of the business. Accordingly, it is not appropriate to charge a Salary Expense account and to credit a Salary Payable account. hi However, some partnerships record salary allowances in this manner, Although this is not technically correct, it does not affect the final profit and loss allocation. The salaries allowed are proportionate to the period the services were actually rendered by ‘pariners to the partnership.» The bonus; however, is always based on profit. “g * The intent 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 interest, salaries and most particularly the amount of the bonus. SPECIAL PROFIT ALLOCATION METHODS Some partnerships distribute profit on the basis of other criteria, Imost public accounting firms distribute profits on the basis of partné: A new partner acquires a certain number of units and additional uni by a firmwide compensation committee based on: * obtaining new clients, Providing the firm with specific areas of ind i v lustrial expertise, serving as a managing partner of a local Office, or . accepting a variety of other responsibilities. For example, ship “units”, its are assigned Many Partnerships use profit and loss. sharin; g formula, that giy, specific performance of re, some weight to following: ofeach partner. Some of these performance methove ike * chargeable hours Ea Mowteyo 3 via total billings «46 hed ans that teflect the;eamings oft : ental firms allocate profi oa Partnership. For example, some: medical27. Chapter 1- Partnership Formation and Operations basis of billed services, Other criteria may include number or size of clients, years of service within the firm, or the partner’s position within the firm. CORRECTIONS IN NET PROFIT FOR ERRORS AND | suintured? OMISSIONS PRIOR TO DISTRIBUTION cet "t 4 The partnership books may show an incorrect profit because of errors and omissions such as failure to record prepaid expenses, accrued expenses, accrued income, unearned income, overstatement or understatement in purchases, inventories, and depreciation. ‘Such reported profit should be corrected before it is distributed to the partners. ‘ The above mentioned errors may also affect the computation of a prior period’s profit. The central issue, however, is whether the correction would affect the profit of the current year (the year in which the error is discovered) or the profit of the prior year (the year in which the error occurred). When the error is corrected as adjustment to prior year’s profit, the allocation of profit for the prior year should be recalculated based on the corrected profit and the profit-and-loss sharing agreement in effect during the prior period. When the error is corrected as adjustment to current year’s profit only, the adjustment is allocated among capital accounts based on the corrected current year’s profit and the profit and loss sharing agreement. The two adjustment methods produce different capital balances if the profit and loss sharing procedure or the identity of the partners changes while the error remains undiscovered. Generally, most corrections to financial statements affect current profit. However, when the partnership agreement specifies that particular items be treated as prior-period adjustments, the partnership agreement should be followed. The required corrections to profit are summarized as follows: : Corrections to profit of Current year for errors. made in Overstatement of inventories Understatement of inventories Prior year Current year 1, Unrecorded prepaid expenses . a hee 2. Unrecorded accrued expenses + _ 3. Unrecorded accrued income 6 < 4. Unrecorded unearned income ot! 7 2 . 6.28 Seen } Chapter 1 - Partnership Formation and Operations | Overstatement of purchases + Understatement of purchases aang Overstatement of depreciation aeae Understatement of depreciation + + i tions TO) It is understood that the tax implications of ee oe tiie : ee accounted for especially if the partnership is no’ partnership. Mlustrative Problem F: Gomez, Halili and Isla are partners — ae 7 a 2:3:5 ratio. On January 1, 2016, Jacinto was admitted into the partnership wit a 20% share in profits. The old partners shall continue to participate in profits in proportion to their original ratios. For the year 2016, the partnership books showed a profit of P796,000. It was ascertained, however, that the following errors were made: lL 2. 3. 4. 5. The corrected profit for 2016 after income tax considerations is as follows: Accrued expenses not recorde Accrued expenses not recorded at the end of 2015 Overstatement of 2016 ending inventory Goods received and inventoried in 2016 but the related purchases not recorded Income received in advan recorded at the end of 2015 Prepaid expenses not recorded at the end of 2015 ce (unearned income), not dat the end of 2015 Uneamed income not recorded at the end of20s. Pra Overstatement of 2016 ending inventory P 96,000 Unrecorded purchases of 2016 40.0 0 Unrecorded prepaid expenses at the end of 2015 oa Net adjustm Net adjustment Reported profit ent before income tax — 6,000 after income tax Corrected profit P 10,000 | 96,000 40,000, 20,000 6,000 P 30,000. 142,000)) (P112,000) x 70% (P78,400) 796,000 P717,600_,29 Chapter 1~ Partnership Formation and Operations » \d loss ‘The distribution of the corrected profit shall’be based on the new profit an ratios computed as follows: Gomez 20% x» 80% lees ‘ Halili 30% x 80% 24% Isla 50% x 80% 40% Jacinto . 20% 100% The corrected profit shall be divided among the partners as follows: Gomez 16% P 114,816 P717,600 x Halili P717,600 x 24% 172,224 Isla P717,600 x 40% 287,040 Jacinto P717,600 x 20% | 143,520 P_717,600 CAPITAL RATIO ADJUSTED TO PROFIT AND LOSS RATIO \ a eit is usual that capital ratios do'not equal profit and Toss ratios, partes may” 4 to bring their capital balances into their profit and loss ratio. / This can be accomplished through either of the following: 1. The capital balances are to be brought into the profit and 'loss ratio by payments outside of the firm among the partners and where the total firm capital is to remain the same. 2. The capital balances are to be brought into the profit and loss ratio by the lowest possible additional cash investment in the firm by the partners, 3. The capital balances, are, to be brought into the profit and loss ratio by the lowest possible additional investment or cash withdrawal from the firm: by the partners. Illustrative Problem G. Kaimo, Lopez, and Marcos are partners whose original Capital balances were in their profit and loss ratio. On December. 31; 2015 Ge ital balances are as follows: : - ae Kaimo 490,000 20% < Lopez 200,000 35% hs Marcos 400,000 45%it tion and Operations. = Partnership Format Chapter 1 30. want to bring thei ital be i i and loss ratio. ' ing their capital balances into their profit 1s Partners Assumpti aime P4000 ,000, 000 200,000 Teel nae 350,000. __450,000 __1,000,000 Required capita 000 3 1,000,000 )) _(P50,000) Cash received (paid) 200,000 (P150,000) _(P. tio and the total For the capital balances to be brought into the profit seta pa Seen Piso firm capital to remain the same, Lopez and Marcos ha and P50,000, respectively. The entry required on the partnership books is ag follows: . Kaimo, Capital 200,000 ea Lopez, Capital $0,000 Marcos, Capital , Assumption t c h investment i ’ Kaimo Lopez Marcos Total, § Capital balances P400,000 P200,000 P 400,000 P1,000,00¢ Required capital 400,000 _ 600,000. 1,000,000 Additional investment 2,000,000 7 400,000. “p 600,000 P1,000 00¢ 400,006 / 20% 200,000, 200,000 / 300% = 666,666; P400,000 / 50% = P800,000 - rt , In order to bring bring the capital balances into the profit and. | io by : ae en sesh snvestment, use the capital of Kaimo diehiee: ty arf Share as the basis for determining the required » car: =P2,000,000), The required entry on the books othe beak Se Partnership is as follows: Cash : ji Lopez; Capital 1,000,000 Marcos; Capital 400,000 9: ‘* 600,00031 chapter 1= Partnership Formation and Operations profit and loss ratio DY it Total Kaimo Lopez Marcos Capital balances P400,000 -P200,000, P400,000 FNS Required capital _ 160,000 _ 240,000 __ 400,000 __80U.S°" Additional investment z (Withdrawal) (P240,000) P_40,000 eile P_200,000 In order to bring the capital balances into the profit and loss ratio by the lowest possible additional investment or cash withdrawal from the firm by the partners, use the capital of Marcos divided-by his profit share as the basis for determining the required capital peers 800,000.) The required entry on the books of the partnership is as follows> nighett Kaimo, Capital 240,000 Cash 200,000 Lopez, Capital 40,000