Partnership Operations (PDF)

Module 3: PARTNERSHIP OPERATIONS Overview This module gives us a background on how the partnership divides its profits and losses to partners. Learning Objectives: After studying this module, the students should be able to 1. Differentiate the closing en...

Module 3: PARTNERSHIP OPERATIONS Overview This module gives us a background on how the partnership divides its profits and losses to partners. Learning Objectives: After studying this module, the students should be able to 1. Differentiate the closing entries in a partnership and in a sole proprietorship. 2. Determine the factors affecting the distribution of profits and losses. 3. Identify the different methods and rules of dividing partnership profits and losses among partners. 4. Understanding on how to prepare the financial statements of a partnership NATURE OF PARTNERSHIP OPERATION Basically accounting for partnership operations and accounting for the operations of a sole proprietorship is essentially the same. Steps of the accounting cycle and the rule of debit and credit to record the transactions are also the same for both sole proprietorship and partnership. Purchased of office chairs and table on account is debited to Furniture and Fixtures and credited to Accounts Payable. Payment of expenses is debited to Expenses and credited to Cash. Sale of merchandise on account is debited to Accounts Receivable and credited to Sales. Collection of accounts is debited to Cash and credited to Accounts Receivable. At the end of the accounting period, adjustments are made for merchandise inventory, accruals, prepayments, provision for uncollectible accounts, and provision for depreciation. Profit or loss is determined in the usual manner, that is, by matching periodic income and expense. 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 income / statement of comprehensive income b. Statement of financial position c. Statement of changes in partners’ equity ✔ CLOSING ENTRIES OF A PARTNERSHIP The procedures for the preparation of closing entries for a partnership are similar to that of a sole proprietorship. First, all revenue and other nominal accounts with credit balances (such as Purchases Discounts and Purchases Returns and Allowances) are debited and Income Summary is credited. Second, income Summary is debited and all expense and other nominal accounts with debit balances (such as Sales Discounts and Sales Returns and Allowances) are credited. Third, the balance of the Income Summary account, which represents profit or loss of the partners. Finally, the balance of the drawing account of each partner is transferred to his/her capital account. The balance of the Income Summary account is transferred to the drawing accounts of the partners if the partners‟ intention is to keep the capital account intact for investments and permanent withdrawals of capital. A credit balance in the Income Summary account represents a profit and its balance is transferred to the drawing accounts of the partners based on their profit and loss sharing ratio. The entry is as follows: Income Summary 000 X, Drawing 000 Y, Drawing 000 Any resulting credit balance in the drawing account of a partner may be withdrawn by the partner or reinvested into the firm. If the balance in the drawing accounts is withdrawn in cas, the entry is as follows: X, Drawing 000 X, Cash 000 However if the partner decides to reinvest into the firm this balance in his drawing account, the entry is as follows: X, Drawing 000 X, Capital 000 A debit balance in the Income Summary account represents a loss and its balance is transferred to the drawing accounts of the partners based on their profit and loss sharing ratio. The entry is as follows: X, Drawing 000 Y, Drawing 000 Income Summary 000 The resulting debit balance in the drawing account of a partner is charged against his capital with the following entry: X, Capital 000 X, Drawing 000 On the other hand, the balance of the Income Summary account may be transferred directly to the capital accounts of the partners if the partners‟ intention is to make the profit or loss a part of permanent capital. It should be noted, however, that either treatment will result to the same net effect on partners‟ ending capital balances. All illustrations mentioned, pertaining to distribution of profit or loss are recorded directly to the capital accounts with the assumption that partners intend to make their respective share on the profit loss as a direct part of their permanent capital. A credit balance in the Income Summary account represent a profit and its balance is transferred to the capital accounts of the partners based on their profit and loss sharing ratio. The entry is as follows: Income Summary 000 X, Capital 000 Y, Capital 000 A debit balance in the Income Summary account represents a loss and its balance is transferred to the capital accounts of the partners based on their profit and loss sharing ratio. The entry is as follows: X, Capital 000 Y, Capital 000 Income Summary 000 ✔ DISTRIBUTION OF PROFIT AND LOSSES To make distribution of partnership profits and losses equitable, the following factors are considered: 1. Services rendered by the partners to the partnership- SALARY 2. Amount of capital contributed by the partners to the business- INTEREST 3. Entrepreneurial ability or managerial skill of the partners - BONUS 4. PROFIT AND LOSS RATIO (REMAINDER) RULES FOR DIVIDING PROFITS AND LOSSES Profits and losses in general shall be divided in accordance with the agreement among the partners. In the absence of an agreement, the partners shall share in the profits in proportion to their capital contributions after satisfying the share of the industrial partner on such profit. The following is the list of rules in the division of profits and losses of the partnership based on the provision of the New Civil Code: 1676-1867 1. As to Capital Partners a. Division of profits 1. in accordance with agreement 2. in the absence of an agreement, division of profits is in accordance with capital contributions b. Division of losses 1. In accordance with agreement 2. If only division of profits is agreed upon, the division of losses will be the same as the agreement on the division of profits 3. In the absence of an agreement, division of losses is in accordance with capital contributions 2. As to Industrial Partners a. Division of profits 1. In accordance with agreement 2. In the absence of an agreement, the industrial partner shall receive a just and equitable share of the profits and the capitalist partners shall receive profits in accordance with their capital contributions b. Division of losses 1. In accordance with agreement 2. In the absence of an agreement, the capitalist- industrial partner in his/her character as industrial partner shall have no share in the losses, but in his/her character as a capitalist partner will share in proportion to the capital contribution METHODS OF DISTRIBUTING PROFITS BASED ON PARTNERS’ AGREEMENT 1. 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 operations. 2. 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 operations. 3. Interest on capital and the balance on agreed ratio- this method recognizes the differences in the capital contributions but does not take into account the time and effort that partner may devote in running the firm‟s business operations. Interest is allowed to partners for the use of invested capital. Interest as agreed by the partners shall be allowed in proportion over the period such capital was actually used. Moreover, the interest shall be provided whether profit is sufficient or insufficient or there is a net loss unless otherwise agreed upon by the partners. 4. Salary allowances to partners and the balance on agreed ratio- this method recognizes the time and effort that a partner may devote in running the firm‟s business operations but does not take into consideration the differences in capital contributions. Salaries are allowed to partners as a compensation for their time devoted in the business. Salaries as agreed by the partners shall be allowed in proportion to the time the partners actually rendered services to the firm. Such salaries shall be provided whether the profit is sufficient or insufficient or there is net a loss unless otherwise agreed upon by the partners 5. Bonus to managing partner and the balance on agreed ratio- this method allows a bonus, as an incentive, to the managing partner. It is usually a percentage of the profit. Bonus, therefore, is allowed only when there is a profit. It may be computed using any one of the following as basis: a) Bonus is based on profit before deducting bonus and income tax b) Bonus is based on profit after deducting bonus but before deducting income tax c) Bonus is based on profit after deducting income tax but before deducting bonus d) Bonus is based on profit after deducting both bonus and income tax. 6. Interest on capital, salaries to partners, bonus to managing partner, and the balance on agreed ratio. Profit or loss distribution mode: 1. Salary- industrial 2. Interest 10%, 15%- Capitalist 3. Bonus 4. Profit and Loss Ratio (remainder) Examples: The following accounts and balances are available in the books of Kath and Teo Partnership for the year 2023. Kath, Capital May 1 150,000 Jan 1 Beg Bal 2,200,000 Apr 1 250,000 Oct 1 500,000 End Bal 2,800,000 Kath, Drawing 2023 300,000 Teo, Capital May 1 150,000 Jan 1 Beg Bal 1,500,000 Dec 1 50,000 Oct 1 500,000 End Bal 1,800,000 Teo, Drawing 2023 225,000 Income Summary Dec 31 800,000 Case 1- Profit is divided in the ratio of 75% and 25% to Kath and Teo Income Summary 800,000 Kath, Capital 600,000 Teo, Capital 200,000 P800,000 x 75% = P600,000 P800,000 x 25% = P200,000 Case 2- Profit is allocated based on the beginning capital ratio 2.2 Income Summary 800,000 3.7 Kath, Capital 475,676 Teo, Capital 324,324 1.5 P800,000 x 2.2/3.7 = P475,676 3.7 P800,000 x 1.5/3.7 = P324,324; 800,000- 476,676= 324,324  2.2:1.5 59%: 41% Case 3- Profit is allocated based on the ending capital ratio Income Summary 800,000 Kath, Capital 486,957 Teo, Capital 313,043 P800,000 x 2.8/4.6 = P486,957 P800,000 x 1.8/4.6 = P313,043 Case 4 - Profit is allocated based on the average capital ratio. Income Summary 800,000 Kath, Capital 490,678 Teo, Capital 309,322 P800,000 x 2,412,500/3,933,333 = P490,678 P800,000 x 1,520,833/3,933,333= P309,322 Average capital ratio is a method of dividing profits based on the amount of capital invested and the time during which such capital is actually used in the business. The following steps are to be followed in determining the average capital of each partner using the peso month method; thus, arriving at the average capital ratio: 1) Multiply beginning capital by the number of months that it remained unchanged. 2) Determine each new capital balance in chronological order and multiply by the number of months it remained unchanged. 3) Add the products which represents peso month and divide the total by twelve (12) to obtain the average monthly capital. By following the steps given, the average capital of each partner can be calculated as follows: Kath, Average Capital Jan 1- Mar 31 2,200,000 x 3 =6,600,000 2,200,000 x 12/12= 2,200,000 Apr 1- Apr 30 2,450,000 1 =2,450,000 250,000 x 9/12= 187,500 May 1 – Sept 30 2,300,000 5 =11,500,000 -150,000 x 8/12= -100,000 Oct 1- Dec 31 2,800,000 3 =8,400,000 500,000 x 3/12= 125,000 12 28,950,000 2,412,500 / 12 months P2,412,500 Teo, Average Capital Jan 1- Apr 30 1,500,000 4 6,000,000 May 1- Sept 30 1,350,000 5 6,750,000 Oct 1 – Nov 30 1,850,000 2 3,700,00 Dec 1- Dec 31 1,800,0000 1 1,800,000 18,250,000 / 12 months  P1,520,833 Case 5- Each partner is allowed 12% interest on ending capital and the remaining profit is divided equally. Income Summary 800,000 Kath, Capital 460,000 Teo, Capital 340,000 Alternative entry to record the distribution of profits may be recorded separately as follows: Income Summary 552,000 Kath, Capital 336,000 Teo, Capital 216,000 Interest on ending capital. Income Summary 248,000 Kath, Capital 124,000 Teo, Capital 124,000 Remaining income divided equally Division of profit Kath Teo Total Interest on ending capital 2,800,000 x 12% 336,000 1,800,000 x 12% 216,000 552,000 Remainder 50-50 124,000 124,000 248,000 Total 460,000 340,000 800,000 Case 6- Ciara is allowed a salaries of P600,000 and the remaining profit is divided in the ratio of 1:4 Income Summary 800,000 Kath, Capital 640,000 Teo, Capital 160,000 Division of profit Kath Teo Total Salaries 600,000 600,000 Remainder 1:4  200,000 x 1/4 40,000 200,000 x 3/4 160,000 200,000 Total 640,000 160,000 800,000 Case 7- Dolly, the managing partner, is allowed a bonus of 20% of profit BEFORE bonus and income tax and the remainder is divided in the ratio of beginning capital. Using the income tax rate of 30%, the partnership income before income tax is P1,142,857, that is, net profit of P800,000 divided by 70%. Income Summary 800,000 Kath, Capital 339,769 Teo, Capital 460,231 Division of profit Kath Teo Total Bonus 1,142,857 x 20% 228,571 228,571 Remainder 2.2/1.5 571,429 x 2.2/3.7 339,769 571,429 x 1.5/3.7 231,660 571,429 Total 339,769 460,231 800,000 Case 8- The partners are allowed P5,000 and P10,000 weekly salaries, respectively, 10% interest on average capital, and the remainder is divided in the ratio of 2:3. Income Summary 800,000 Kath, Capital 351,917 Teo, Capital 448,083 Division of profit Kath Teo Total Salaries to partners 5,000 x 52 weeks 260,000 10,000 x 52 weeks 520,000 780,000 Interest on average capital 2,412,500 x 10% 241,250 1,520,833 x 10% 152,083 393,333  Remainder 2:3 -373,333 x 2/5 -149,333 -373,333 x 3/5 -224,000 -373,333 Total 351,917 448,083 800,000 By following the steps given, the average capital of each partner can be calculated as follows: Kath, Average Capital Jan 1- Mar 31 2,200,000 3 6,600,000 Apr 1- Apr 30 2,450,000 1 2,450,000 May 1 – Sept 30 2,300,000 5 11,500,000 Oct 1- Dec 31 2,800,0000 3 8,400,000 28,950,000 / 12 months P2,412,500 Teo, Capital Jan 1- Apr 30 1,500,000 4 6,000,000 May 1- Sept 30 1,350,000 5 6,750,000 Oct 1 – Nov 30 1,850,000 2 3,700,00 Dec 1- Dec 31 1,800,0000 1 1,800,000 18,250,000 / 12 months P1,520,833 The sum of the salary allowance and interest allowed on the average capital of the partners exceeded the profit of P800,000 resulting in a negative remainder (loss or deficit). Such loss is distributed as provided in the profit and loss sharing agreement. Case 9- Assume the same agreement as in Case 8 except that instead of a profit, the partnership has incurred a loss of P100,000. The allowance for salaries and interest will still be provided, thereby resulting in a total loss to be divided as agreed. Teo Capital 91,917 Kath Capital 8,083 Income Summary 100,000 Division of loss Kath Teo Total Salaries to partners 5,000 x 52 weeks 260,000 10,000 x 52 weeks 520,000 780,000  Interest on average capital 2,412,500 x 10% 241,250 1,520,833 x 10% 152,083 393,333 Remainder 2:3 -1,273,333 x 2/5 -502,333 -1,273,333 x 3/5 -764,000 -1,273,333 Total -8,083 -91,917 -100,000 The allocation of partnership profit follows the order of the profit sharing agreement in allocating the bonus, the salary allowances, the interests and the remainder to individual partners. The bonus is computed on the basis of the partnership profit as the concept of “partnership profit” is generally understood in accounting practice. Partners may, however, intend for salary and interest allowances to be deducted in determining the base for computing the bonus. In such case, no bonus is allowed if there is insufficient profit after distribution of salaries and interests. The interests 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 a bonus. Illustrations on the computation of bonus using other assumptions. The same data in example shall be used. Bonus rate is 20% 1. Bonus is based on profit after deducting bonus but before deducting income tax. B =.20 x (P P1,142,857– B) B = P228,571 -.20B B + 0.20b = P228,571 B = P228,571 / 1.20 B = P190,475.83 2. Bonus is based on profit before deducting bonus but after deducting income tax B =.20 (P1,142,857 – T) T =.30 x P1,142,857 = P342,857 Substituting for T in the first equation and solving for B B =.20 x (P1,142,857 – P342,857) B =.20 x P800,000 B = P160,000 Key Points. The bonus was not deducted from the profit subject to income tax. The bonus being computed is not an expense but a distribution of profit after income tax. 3. Bonus is based on profit after deducting bonus and income tax B =.20 (P1,142,857 – B-T) T =.30 x P P1,142,857 = P342,857 Substituting for T in the first equation and solving for B B =.20 x (P1,142,857 – B – P342,857) B =.20 (P800,000 – B) B = P160,000 -.20 B B + 0.20b = P160,000 B = P160,000 / 1.20 B = P133,333 Key Points. In the preceding examples, bonus is treated as distribution of partnership profit, and therefore such bonus is not deductible as an expense in determining the amount of taxable profit. The same is true for salaries and interest allowed on capital. The partnership form of business allows a wide selection of profit distribution ratios to meet the individual desires of the partners. Ratios for profit distributions may be based on the percentage of total partnership capital, time and effort invested in the partnership, or a variety of other factors. Some partnerships, however, have a profit sharing ratio that is different from their loss sharing ratio. To be Added: Worksheet preparation and Correction of Net Income