If an error resulted in an understatement of profit in previous periods, would be needed to increase Capital. If an error overstated profit in ; Capital would have to be decreased. The effect of the error correct based on the applicable profit and loss ratio. 3 Correcting ent Prior periods, then ‘on will be divideg DISTRIBUTION OF PROFITS OR LOSSES BASED ON PARTNERS’ AGREEMENT In general, profits or losses shall be divided in accordance with the partners. The ratio in which profits or losses from partnershi distributed is recognized as the profit and loss ratio. * agreement of the P Operations are The partners may agree on any of the following scheme in distributing profits or losses; 1. Equally or in other agreed ratio 2. Based on partners’ capital contributions: a. ratio of original capital investments b. ratio of capital balances at the beginning of the year c... ratio of capital balances at the end of the year d._ ratio of average capital balances 3. By allowing interest on partners’ capital and the balance in an agreed ratio By allowing salaries to partners and the balance in an agreed ratio. 5. By allowing bonus to the managing partner based on profit and the balance in an agreed ratio 6. By allowing salaries, interest on partners’ capital, bonus to the managing partner and the balance in an agreed ratio (combination of 3 to 5) = Note that the partners can agree on not using a residual sharing ratio (“the balance in an agreed ratio”) if profits do not exceed the total salary and interest allowances. In such @ case, the partners must agree on the priority of the various profit or loss distribution schemes. Illustration. The following series of illustrations are based on the figures obtained from the Medina and Detoya Partnership which had a profit of P300,000 for the year ended Dec. 31, 2016, the first year of operations. The partnership contract provided that each partner may withdraw P5,000 on the last day of each month; both partners did so during the year. The drawings are recorded by debits to the partners" drawing accounts and shall not be considered in the division of profit or loss, It is the intention of the partners that each partner's share in the profit or loss be either credited or debited to the drawing account. Leopoldo Medina invested P400,000 on Jan. 1, 2016 and an additional P100,000 on April 1. Edgar Detoya invested P800,000 on Jan. 1 and withdrew P50,000 on July 1. These transactions and events are summarized in the following capital, drawing and income summary ledger accounts: ; Partnership Operations and Financial Reporting | 57 Scanned with CamScannerLeopoldo Medina, Capital Edgar Detoya, Capital Jan.1 400,000 July1 50,000 Apr.1 100,000 Jan.1 800,099 Leopoldo Medina, Drawing Edgar Detoya, Drawing Jan.~Dec. 60,000 Jan,- Dec. 60,000 Income Summary Dec. 31 300,000 Equally or in other Agreed Ratio Partnership contracts may provide that profit or loss be divided equally. The profit ¢ 300,000 for the Medina and Detoya Partnership is transferred by a closing entry o, Dec. 31, 2016, from the income summary ledger account to the partners’ drawing accounts: Income Summary 300,000 Leopoldo Medina, Drawing 150,000 Edgar Detoya, Drawing 150,000 If the partnership had a loss of P200,000 for the year ended Dec. 31, 2016, the income summary ledger account would have a debit balance of P200,000. This loss would te transferred to the partners” drawing accounts by a debit to each drawing account for P100,000 and a credit to the income summary account for P200,000. Leopoldo Medina, Drawing 100,000 Edgar Detoya, Drawing 100,000 Income Summary 200,000 To record the division of losses. Assume instead that Medina and Detoya share profits and losses in a ratio of 60:40 and profit was P300,000, the profit would be divided as follows: Income Summary 300,000 Leopoldo Medina, Drawing 180,000 Edgar Detoya, Drawing 120,000 To record the division of profits. Computation:’ Medina: 60% x 300,000 180,000 Detoya: 40% x P300,000 120,000 300,000 Based on Partners’ Capital Contributions Division of partnership profits in proportion to the capital invested by each partner is most likely to be found in partnerships in which substantial investments is the princip2! 58 | Partnership and Corporation Accounting Scanned with CamScanneringredient for success. It is essential that the partnership contract be specific with respect to the concept of capital. Capital may refer to either of the following Ratio of Original Capital Investments. Assume that the partnership agreement provides for the division of profits in the ratio of original capital investments. The original investments of Medina and Detoya are P400,000 and P800,000, respectively. The profit ‘of P300,000 for 2016 is divided as follows: Income Summary 300,000 Leopoldo Medina, Drawing 100,000 Edgar Detoya, Drawing 200,000 To record the division of profits. Computation: Medina: P300,000 x P400,000/P1,200,000 100,000 ’300,000 x P800,000/P1,200,000 200,000 300,000 After the entry allocating the profits: of P300,000 to Medina and Detoya, are the partners supposed to receive cash for their respective share in the profits? No, the partners’ share in the profits cannot be attributed to any particular asset, including cash. The entry increased the equity of Medina and Detoya in all the assets of the partnership. Ratio of Capital Balances at the Beginning of the Year. Assume that the partnership agreement provided for the division of profits in the ratio of capital balances at the beginning of the year. In this case, the original capital investments are also the capital balances at the beginning of the year since the partnership is only on its first year of operations. The profit of P300,000 for 2016 is divided as follows: Income Summary 300,000 Leopoldo Medina, Drawing 100,000 Edgar Detoya, Drawing 200,000 To record the division of profits. Computation: Medina: P300,000 x P400,000/P1,200,000 P 100,000 Detoya: P300,000 x P800,000/P1,200,000 200,000 300,000 Ratio of Capital Balances at the End of the Year. Assume that the profit is divided in the ratio of capital balances at the end of the year before drawings and the distribution of profit, The ending balances are P500,000 for Medina and P750,000 for Detoya; the profit of P300,000 for 2016 is divided as follows: Income Summary 300,000 Leopoldo Medina, Drawing 120,000 Edgar Detoya, Drawing 180,000 ‘To record the division of profits. Partnership Operations and Financial Reporting | 59 Scanned with CamScannerComputation: Medina: P300,000 x P500,000/P1,250,000 120,000 Detoya: P300,000 x P750,000/P1,250,000 180,000 300,000 Ratio of Average Capital Balances. Division of profits or losses on the basis of the three preceding capital concepts—original capital investments; capital balances at the beginning of the year; or capital balances at the end of the year—may prove inequitable if there are material changes in the capital accounts during the year. When beginning capital balances are used in allocating profits, additional investment, during the year are discouraged because the partners making, such investments are not compensated in the division of profits until the next year. If ending capital balances are used, year-end investments are encouraged, but there is no incentive for a partner to make any investments before year-end. In addition, amounts earlier withdrawn may be reinvested before year-end. These consideration; suggest that using average balances as a basis for distributing profits or losses is preferable because it reflects the capital actually available for use by the partnership during the year. The agreement should also state the amount of drawings each partner may make These drawings are considered temporary and are recorded as debits to the partner's drawing account. Drawings within the allowable amount will not affect the computation of the average capital balance. On the contrary, drawings in excess of the allowable amount are ‘considered permanent reductions in capital; hence, the computation of the average capital balance is affected. in the continuing illustration for the Medina and Detoya Partnership, the partners are entitled to withdraw P5,000 monthly or a total of P60,000 per annum. Any additions! withdrawals are directly debited to the partners’ capital accounts and therefore will affect the computation of the average capital ratio. : Medina and Detoya Computation of the Average Capital Balances For the Year Ended Dec. 31, 2016 Leopoldo Medina, Capital Date Capital Account Portion® of the ge Capit Balances Year Uni Balances fan. 400,000 x 3/12 : 100,000 Ape 500,000 x ona : 375,000 Average Capit y _PA75,000 60 | Partnership and Corporation Accounting Scanned with CamScannerEdgar Detoya, Capital Jan. 1 800,000 x 6/12 July 1 750,000 x 6/12 = Average Capital Total Average Capital Balances * the fractions for each partner should add up to 12/12 or 1, This convention wil help minimize counting errors a5 to the number of months the capital balance went unchanged. To state the ‘obvious, there are only 12 months in a year. For example, for Partner Medina, the fraction wil total to 12/12 [3/12 + 9/12» 12/12 Jor 1 The entry to record the division of P300,000 profits Js as follows: Income Summary 300,000 Leopoldo Medina, Drawing 114,000 Edgar Detoya, Drawing, 186,000 To record the division of profits. Computation: Medina: P300,000 x P475,000/P1,250,000 114,000 Detoya: P300,000 x P775,000/P1,250,000 186,000 300,000 By Allowing Interest on Capital and the Balance in an Agreed Ratio In the preceding section, the plan for dividing the total’profits in the ratio of partners’ capital balances was based on the assumption that capital investments were the controlling factor in the success of the partnership. However, it is not always the case. Consequently, partnerships may choose to allocate a portion of the total profits in the capital ratio and the balance equally or in other agreed ratio after due consideration of the partners’ other contributions. To allow interest on partners’ capital account balances is-almost similar to dividing part of profits in the ratio of partners’ capital balances. If the partners agree to allow interest on capital as a first step in the division of profit, they should specify the interest rate to be used. It should also state whether interest is to be computed on capital balances on specific dates or on average capital balances during the year. Partners invested in a partnership for profits, not for interest. The interest on partners’ capital, along with the other profit sharing plans to be discussed in the remainder of the chapter, are to be considered as mere techniques to share partnership profits or losses equitably and not as expenses of the partnership. On the other hand, the interest on Joans from partners is recognized as expense and a factor in the measurement of profit or loss of the partnership. Similarly, interest earned on loans to partners is recognized as partnership income. This treatment is consistent with the discussion in Chapter 1 that loans receivable from or payable to partners are assets and liabilities, respectively of the partnership. g Partnership Operations and Financial Reporting | 61 Scanned with CamScannerhip with a profit of P300, 1 the partnership agreeme,, h the balance to he stoya Partners! assume tha! P int balances, wit! ided as follows: Continuing the illustration of Medina and De for 2016 and capital balances as already shown, allowed 15% interest on average capital accout divided equally. The profit of 300,000 for 2016 is divi Medina etoya “Total 15% Interest on Average Capital: Medina: P475,000 x 15% P 71,250 Detoya: P775,000 x 15% 116,250 Peso Subtotal Balance to be Divided Equally {P300,000 - P187,500 = P112,500); Medina: P112,500 x 50% 56,250 Detoya: P112,500 x 50% - 56,250 a Share of Partners in Profits 127,500 _P172,500_P300, The journal entry to close the income summary ledger account on Dec. 31, 2016 follows: Income Summary 300,000 Leopoldo Medina, Drawing Edgar Detoya, Drawing To record the division of profits. 127,500 172,500 Ina related case, assume that the Medina and Detoya Partnership had a loss of P10,000 for the year ended Dec. 31, 2016. /f the partnership agreement provided for interest on capital accounts, this provision must be honored regardless of whether operations yielded profits or not. The loss will be shared by the partners in the same manner as the P300,000 profit. The total interest allowance of P187,500 would still be given to the partners. The only difference is that the division of profits or losses after the interest allowances would involve a larger negative amount of P197,500 which will be divided equally between Medina and Detoya: Medina Detoya Total 15% Interest on Average Capital: Medina: P475,000 x 15% P 71,250 Detoya: P775,000 x 15% P. Subtotal oe Aro) Balance to be Divided Equally ° {(P10,000) - P187,500 = P(197,500)} Medina: P(197,500) x 50% 98, Detoya: P(197,500) x 50% eu) Subtotal (98,750) Share of Partners in Profits (Losses) P(27,500) 027.500) P17,500__P (10,000) 62 | Partnership and Corporation Accounting Scanned with CamScannerThe journal entry to close the incorne summary ledger account on Dec. 21, 2016 follows Drawing, 2 Leopoldo Medi Income Summary Edgar Detoya, Drawing, To record the division of to 10,000 17,500 Alter initial consideration, the idea that a loss of P10,000 should cause one partner's capital to increase and the other partner's capital to decrease may appear unreasonable. However, this result was planned and was with good reason. Partne Detoya invested more capital than Partner Medina; this capital was ed to carry out operations, and the partnership's incurrence of a loss in the first year is no reason to disregard Detoya’s larger capital investment. based solely on capital ratios as against distribution with There will be a significant difference between the two is operating, at a loss. Under the capital ratio plan, | will ultimately shoulder a bigger share of the uitable because the investment of capital Comparison of distribution interest on capital balances. distribution plans if the partnership the partner who invested more capital loss. This result may be considered ineq' presumably is not the cause of the loss, sted more capital is credited (increased) Under the interest plan, the partner who inve: fecreased) with a lesser share of for an interest on his capital and is ultimately debited (di the loss; in some cases, the result may even be a net credit (increase). By Allowing Salaries to Partners and the Balance in an Agreed Ratio g the personal The sharing agreement may provide for variations in compens ted by partners. Even among partners who devote equal service time, services contribui jand a greater share of the one partner's superior experience and knowledge may comm: profit. To acknowledge the harder working or more valuable partner, the profit-sharing plan may provide for salary allowances. The partnership agreement should be clear on the treatment of salary allowances when losses are incurred, In the absence of an agreement to govern this situation, salary allowances will be provided even when operations yielded losses. This allowance should not be confused with salaries expense or with the partner's drawing account which is debited for periodic salary allowances. The cash withdrawals will in no way affect the division of profits; the division of profits is governed by the sharing agreement. Partners are the partnership's owners; they are not employees of the business. If partners devote their time and services to the affairs of the partnership, they are understood to do +o for profit, not for salary. Therefore, when the partners calculate the profit of the partnership, salaries to the partners are not deducted as expenses in the statement of recognized income and expense Partnership Operations and Financial Reporting | 63 Scanned with CamScannerership, assume that Continuing the illustration for the Medina and Detova Pan 100,000 to Medina . partnership agreement provided for an annual salar a profit af P300,000 60,000 to Detoya, and the balance to be divided equallY: 7 2016 is divided as follows: Medina betoya Total — 160,000 Salary Allowances p100,000 — P-60,000 Balance to be Divided Equally 1 P300,000 - P160,000 = P140,000)I: Medina: P140,000 x 50% 70,000 , 140,000 Detoya: P140,000 x 50% 70,000 170,000 130,000 300,000 Share of Partners in Profits The journal entry to close the income summary ledger account on Dec. 31, 2016 follows. Income Summary 300,000 pean Leopoldo Medina, Drawing Edgar Detoya, Drawing 130,000 To record the division of profits By Allowing Bonus to the Managing Partner Based on Profit and the Balance in an Agreed Ratio A partnership contract may provide for a special corhpensation in the form of bonus to the managing partner when the results of operations of the partnership are favorable. This allowance is given in order to encourage the partner to maximize the profit potentials of the partnership. Bonus is not being consideréd in the computation of profit, rather it is a mere technique to distribute profits. Assume that the Medina and Detoya Partnership agreement provided for a bonus of 25% of profit before bonus to Partner Medina and the balance to be divided equally. The profit is P300,000. . Medina Detoya Total Bonus { 25% x P300,000 }: P 75,000 P 75,000 Balance to be Divided Equally {P300,000 - P75,000 = P225,000)]: Medina: P225,000 x 50% 112,500 Detoya: P225,000 x 50% P112,500 225,000 ——P112,500__225,000_ Share of Partners in Profits £187,500 __P112,500 300,000 a __P300,000_ 64 | Partnership and Corporation Accounting Scanned with CamScannerthe income summary ledger account on Dec. 31, 2016 fo ows: The journal entry to close 300,000 Income Summary Leopoldo Medina, Drawing 187,500 toya, Orawing 112,500 Edgar De' ne division of profits. To record th and Detoya Partnership agreement provided for a fit after bonus to Partner Medina and the balance to be divided It is understood in the wording of the agreement that the 25% bonus will be nce after deducting bonus from a certain amount. This certain {ter considering all the operating expenses but before this bonus. Assume instead that the Medina bonus of 25% of pro! equally. based on the differe amount is the profit a I includes the bonus. The difference between this profit s for the 25% bonus rate. Hence, profit after bonus 300,000 before bonus represents 125%. Here, the P300,000 profit still and bonus shall be the basi represents 100% while the profit of P Profit before Bonus 300,000 125% _-240,000_100%_ profit after Bonus (P300,000/125%) Bonus P 60,000__25% Medina ——Detoya Total Bonus P 60,000 P 60,000 Balance to be Divided Equally [ P300,000 - 60,000 = P240,000)]: Medina: P240,000 x 50% 120,000 P120,000 240,000 Detoya: P240,000 x 50% Share of Partners in Profits p1g0,000 _P120,000__P 300,000 The journal entry to close the income summary ledger account on Dec. 31, 2016 follows: Income Summary 300,000 Leopoldo Medina, Drawing 180,000 Edgar Detoya, Drawing . 120,000 To record the division of profits. By Allowing Salaries, Interest on Capital, Bonus to the ‘Managing Partner and the Balance in an Agreed Ratio nd capital contributions of the partners salary allowances can ¢ are not equal, interest allowances When both service and capital contributions are ay include salary allowances, interest on and the balance to be divided in are often not equal. -ompensate for the can make The service contributions a If the service contributions are not equal, differences. Or, when capital contributions up for the unequal investments, unequal, the allocation of profits or losses m their capital balances, bonus to the managing partner. an agreed ratio. ortnership Operations and Financial Reporting | 65 Scanned with CamScannerNote that the provisions for salaries and interest in the partnership agreement ag called allowances, These allowances are not reported in the ee moet income and expense as salaries and interest expense; they are merely means gy allocating profit to the partners. ‘Assume that the profit for the year is P400,000 and the partnership agreement for th, Medina and Detoya Partnership provided for the following: 1. Bonus to Medina of 25% of profit after salaries and interest but before bonus, 2. Annual salaries of P100,000 to Medina and P60,000 to Detoya; 3. Interest on average capital balances of P71,250 and P116,250 to Medina ang Detoya, respectively; 4, Balance to be divided in a ratio of 40:60. Medina Detoya Total Salary Allowances 100,000 60,000 —P160,000 Interest on Average Capital Balances 71,250 116,250 187,500 Bonus [ 25% (P400,000 - P100,000 - 13,125 13,125 60,000 - P71,250 - 16,250) }: Balance to be Divided in a Ratio of 40:60 [ P400,000 - P160,000 - P 187,500 - P13,125 = P39,375]: . Medina: P39,375 x 40% 15,750 Detoya: P39,375 x 60% 23,625 39,375 Share of Partners in Profits P200,125 __P199,875__ 400,000 The journal entry to close the income summary ledger account on Dec. 31, 2016 follows Income Summary 400,000 Leopoldo Medina, Drawing 200,125 Edgar Detoya, Drawing 199,875 To record the division of profits. Assume instead that the bonus to Medina is 25% of profit after salaries, interest 2% after bonus. The computation of the bonus follows: Profit before Salaries, Interest and Bonus. 400,000 Less: Salaries 160,000 Interest _187,500__347,500_ Profit after Salaries and Interest but before Bonus ~~ P52,500 ° 325% Profit after Salaries, Interest and after Bonus* 42,000__ 100% Bonus 30,500 25% +*p52,500 divided by 125% = P42,000. 66 | Partnership and Corporation Accounting Scanned with CamScannerMedina Detoya Total P100,000 60,000 160,009 salary Allowances 71,250 116,250 187,509 interest on Average Capital Balances Bonus 10,500 10500 Balance to be Divided in a Ratio of ‘40:60 [ P400,000 - P160,000 - 187,500 - P10,500 = P42,000): Medina: P42,000 x 40% 16,800 25,200___42,000 Detoya: P42,000 x 60% share of Partners in Profits P198,550__P201,450__P400,000 ‘te journal entry to close the income summary ledger account on Dec. 31, 2016 follows: Income Summary 400,000 Leopoldo Medina, Drawing Edgar Detoya, Drawing To record the division of profits. 198,550 201,450 Some of the topics below are required inclusions in this subject per Commission on Higher Education Memorandum Order No. 3 (series of 2007), As Amended. Unfamiliar terms in the succeeding discussions which are partly based on IAS No. 1 (revised 2007) will be fully appreciated in higher accounting subjects. Suffice it to say, though, that at this point you're in a better situation than the users of other textbooks. The International Accounting Standards Board (IASB) issued a revised International Accounting Standards (IAS) No. 1, Presentation of Financial Statements last Sept. 6, 2007. This standard supersedes the 2003 version of IAS 1 as amended in 2005. IAS No. 1 (revised 2007) is effective for periods beginning on or after 1 January 2009. FINANCIAL REPORTING Purpose of Financial Statements Financial statements are a structured representation with the objective of providing information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of the management's stewardship of the resources entrusted to it, To meet the objective, financial statements provide information about an entity's assets, liabilities, equity, income and expenses, other changes in equity and cash flows. Overall Considerations al Financial Reporting Standards Fair Presentation and Compliance with Internation financial (IFRSs). The financial statements shall present fairly the financial position, Partnership Operations and Financial Reporting | 67 Scanned with CamScanner