CHAPTER 18 PARTNERSHIP OPERATION

Introduction
The operations of a partnership are similar in most respects to those of other
forms of organizations operating in the same line of business. At the end of each
fiscal year, when revenues and expenses are closed out, some assignments must
be made of the resulting income figure because a partnership will have two or
more capital accounts rather than a single retained earnings balance. This
allocation to the capital accounts is based on the agreement established by the
partners preferably as a part of the Articles of Partnership.
A wide range of profit allocation is found in the business world. Some
partnerships have straightforward distribution plans while others have
extremely complex ones. It is the accountant's responsibility to distribute the
profit or loss according to the partnership agreement regardless of how simple
or complex that agreement is. Profit distributions are similar to dividends for a
corporation
Accounting for Partnership Operations: Methods to Allocate Net
Income or Loss
In measuring partnership profit for a period, expenses should be
scrutinized to make sure that partners' 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. Drawings are closed to the capital accounts of the partners
rather to an income summary account.
Practically all partnerships have a profit or loss allocation
agreement. It would be rare to find a partnership that did not
spell out the divisions of profits or losses in details. The agreement
must be followed precisely, and if it is unclear, the accountant should
make sure that all partners agree to the profit or loss distribution.
Partners should select a formula that is sensible, practical, and
equitable. The formula used to divide profits and losses is
determined through negotiations among the partners. Whether
it is fair or not, it does not concern the accountant.
It is necessary that the benefit the partners expect to obtain from the
combination of their respective contribution should be common to
all the partners, because if such were not the case, there would be no
partnership.
Now the question that arises is: "How will the partners divide the
profits or losses resulting from the operation of the partnership?"

1
The Partnership Law provides that 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. It also provides that in
the absence of agreement, the share of each partner in the profits
and losses shall be in proportion to what they have contributed
(based on capital contribution), but the industrial partner shall
receive such share as may be just and equitable under the
circumstances.
However, the law is not clear as to what capital balances shall be
applied, whether the capital balances refers to original capital
beginning or end of each period or the average capital during
the period. In as much as the law does not clearly specify the
capital balance, it is therefore, presumed to be the original
capital, in the absence of such original capital it should be the
beginning capital.
The reason behind the usage of original capital (in his absence, the
beginning capital) is that, if at the time of formation there is no
agreement, the law should apply and the only available capital
balance is the original capital. Even though usage of original capital
seems to be unreasonable because of inequity, logic dictates that
profit and loss should be established at the time of formation due to
some of the following reasons:
1. Subsequent adjustments in assets and liabilities;
2. Admission of a new partner:
3. Retirement or withdrawal of a partner, and
4. Liquidation of partnership.
All of the above reasons require the use of profit and loss ratio.
The wait period for the end-of-the-year balances to determine
the average or ending capital would be in exercise of futility
because of the urgency of profit and loss ratio. Deferral of such
action would not address the above reasons.
In the United States, in the absence of any agreement, profit or loss
should be allocated equally and if they agreed on capital balances it
is presumed to be the average capital. Nevertheless, these are
practices which are not applicable under Philippine setting because
of its differing law provisions.
Profits and loss can be shared in many ways among partners of a
partnership. Most profit and loss sharing formula includes one or
more of the following features or techniques:

2
 1. Equally;
2. Arbitrary ratio;
3. In the ratio of partner's capital account balances and the
dividing the balance on agreed ratio;
a. Original capital-the initial investment/capital at the time
of formation.
b. Beginning capital of the period
c. Average capital
 Simple average
 Weighted average
- Peso-day approach
- Peso-month approach
4. Interest on partners' capital accounts and dividing the balance
on agreed ratio.
5. Salaries to partners and dividing the balance on agreed ratio
6. Bonus to partners and dividing the balance on agreed ratio;
and
7. Interest on capital account balance, salaries and bonus to
partners and dividing the balance on agreed ratio.
Because of its simplicity, the equally or the arbitrary ratio approach
is the most common of allocating profit or loss. It is simple because
it ignores capital balances.
Assigning profit based equally or on an arbitrary ratio may be
simple, but this approach is not necessarily equitable to all partners.
No single ratio is likely to reflect properly the various contributions
made by a partner. Indeed, on unlimited number of alternative
allocation plans could be devised in hope of achieving fair treatment
for all parties,

Illustration 18-1: Allocation of Net Income

Assume that a net income of P288,000 is determined for X and Y
Partnership at the end of 20x4 Regular withdrawals by partners in
anticipation of net income have been summarized in the drawing
accounts; permanent capital changes have been summarized in the
capital accounts. Drawing and capital accounts at the end of 20x4
appear as follows:

X, capital Y, capital

3
 1/1/20x4 300,000 3/1/20x4 30,000 1/1/20x4 420,000
4/1/20x4 60,000 11/1/20x4 60,000
12/1/20x4 360,000 12/1/20x4 450,000

X, drawing Y, drawing
1/1 – 12/1 36,000 1/1 – 12/1
114,000
36,000 114,000

Equally
This method may be proper when the capital or service contribution
of the partners are considered to be the same.
The entry of the partnership of X and Y to record the allocation of
net income of P288,000 equally would be as follows:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,000
X's share of net income ½ of P 144,000
P288.000 . . . . . . . . . 144,000
Y's share of net income ½ of P 288,000
P288.000 . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The resulting balances in the drawing accounts may be closed into
the capital accounts.

Arbitrary Ratio
When the capital and service contribution of the partners are
unequal, an arbitrary profit ratio may be employed to recognize
these differences.
An infrequently used variation of this method specifies one ratio for
profits and a different ratio for losses. Because profit and loss years
may alternate, it is extremely important that profit or loss for each
year be determined accurately in all material respects when this
variation is used. Although agreements to share profits and losses
equally or in specified ratios are common, more complex profit-
sharing agreements are also encountered in practice. The time that
partners devote to the partnership business and the capital
contributed in the business by individual partners are frequently
considered in determining, the profit-sharing agreement.

4
Assume that, since the expertise, ability, and reputation of X are
factors of special significance to the success of the partnership. X
and Y agree to allocate net income in the ratio of 3:2. The entry to
record the net income of P288,000 is
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,800
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,200
X's share of net income 3/5 of P288.000 . . . . . . . P 172,800
Y's share of net income 2/5 of P288.000 . . . . . . . 115,200
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000

Capital Balances
Many firms allocate profits and losses solely on the basis of capital
balance. In these cases, each partner must maintain a specified
capital balance that is correlated to the level of responsibility
assumed in the partnership. This method is not only easy to apply
but can also prevent certain inequities from occurring among
partners if the partnership is liquidated. This allocation of profits is
most likely found in limited partnerships in which substantial
investment is the principal ingredient for success.
To avoid argument, it is essential that the partnership contract
specifies whether the profit-sharing ratio is based on (1) the original
capital investments, (2) the beginning capital account balances at
the beginning of each year, (3) the balances at the end of each year
(before the distribution of net income or loss), or (4) the average
balances during each year.
Original Capital. If the agreement between X and Y provides
that the allocation of net income shall be based upon original
capitals, reference would be made to the amounts originally
invested by the partners.
Beginning Capital. When beginning capital balances are used in
allocating partnership profit, additional investments during the
accounting period may be discouraged because the partners
making such investments are not compensated in the division of
profit until a later period. Usage of this will prove to be
inequitable, Assuming this agreement for X and Y, the entry to
record the allocation of net income of P288,000 for the year is:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

5
 Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,000
X, capital, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . P 300,000
Y, capital, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000
Total P 288,000
capitals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

X's share of net income 300/720 of P288.000 . . . . P 120,000

Y's share of net income 420/720 of P288.000 . . . . 168,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000

Ending Capital. A similar problem exists when ending capital

balances are used. Year-end investments are encouraged by their
inclusion in determining each partner's share of profit, but no
incentive exists for a partner to make any investments before
year-end.
Also, no penalty exists for withdrawals if the amounts withdrawn
are reinvested before the period's end. If the partnership
agreement provides for an allocation of net income based upon
partner's capital at the end of each year, the entry to record the
allocation of net income of P288,000 for the year is:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000
X, capital, December P 360,000
31 . . . . . . . . . . . . . . . . . . . . . . . . 450,000
Y, capital, December 31. . . . . . . . . . . . . . . . . . . . . . . . P 810,000
Total
capitals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
X's share of net income 300/720 of P288.000 . . . . P 128,000
Y's share of net income 420/720 of P288.000 . . . . 160,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000
Average Capital. It must have provided the fairest basis for
allocating partnership profit because it reflects the capital
actually available for use by the partnership during the year. An
agreement for the use of average capitals also acts as an incentive for
additional investments when these can be profitably employed.
If the partnership contract provides for sharing profit in the ratio
of average capital account balances during the year, it should
also state the amount of drawings (refer to Chapter 19 for

6
further discussion on drawing accounts) each partner may make
without affecting the capital account. Any additional
withdrawals or investments are entered directly on partners'
capital accounts and therefore Influence the computation of
average capital ratio.
The problem with the average capital computation is what
withdrawal or drawing accounts are to be considered to reduce
capital necessary to compute the average amount. The following
guidelines should be considered:
 An agreement should indicate clearly what withdrawals or
drawings accounts are to be recognized;
 A partnership agreement may state that only withdrawals
above a certain limit are to be viewed as offsets (reduction)
against capital balances. It means that drawing account
balances up to the amounts specified in the agreement would
not be deducted in determining the partners' average or year-
end capital balances. For purposes of allocating partnership
profit. drawings in excess of allowable amounts are deducted
from the partner's capital accounts in computing average or
ending capital balances.
 Typically, either personal withdrawals or temporary
withdrawals or drawing accounts (which are withdrawal
against share in anticipated profit) are not recognized in
the computation of average capital. Conversely, capital
withdrawals or permanent withdrawals (which are
withdrawal against original or additional investments) are
recognized.
The reason for the non-inclusion of the personal withdrawals
in the computation of average capital is that in as much as
profits are generated evenly throughout the year, the figure
itself is already an average amount. Mathematically, the
resulting figure of inclusion of such withdrawals or excluded in
the average capital computation is exactly the same.
The average capital balances for the year can be computed using the
following approach:
1. Simple average. This method is not so widely used by
accountants in view of its failure to take into consideration
the periods of time the changes in capital take place.
2. Weighted average. The partners may wish to recognize all
the changes in their capital as well as in their drawing

7
 accounts in determining the capital ratio to be used in
distributing the profits or losses in the operation of the
partnership. The partnership contract should state whether
weighted capital account balances are to be computed to the
nearest day (using daily balances/peso-day approach) or to
the nearest month (beginning-of-month balances or end-of-
month balances/peso-month approach.)
For 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.
If the allocation of net income is to be based upon average
(weighted) capitals for the year, the entry to record the allocation of
net income of P288,000 for the year is:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,480
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155,520
X: Capital No. of Mos.
Balance Unchanged
1/1//20x4 P 300,000 X 3 P 900,000
4/1//20x4 360,000 X 9 3,240,000
12 P 4,140,000
Average P 345,000

Y: Capital No. of Mos.

Balance Unchanged
1/1//20x4 P 420,000 X 2 P 840,000
3/1//20x4 390,000 X 8 3,120,000
11/1/20x4 450,000 X 2 900,000
12 P 4,860,000
Average P 405,000

X's share of net income 345/750 of P288.000 . . . . P 132,480

Y's share of net income 345/750 of P288.000 . . . . 155,520
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 288,000
The plan for dividing the entire profit in the ratio of partners' capital
account balances was based on the assumption that contributed
capital was the dominant factor in the success of the partnership.
However, in most cases the amount of contributed capital is only one
factor that contributes to the success of the partnership.
Consequently, many partnerships choose to divide only a portion of
the profit by giving interest on capital. salary allowances and bonus.

8
Interest on Capital Balances
The purpose of allowing interest on capital is to give recognition
to differences on capital contributions by partners. It also
recognizes the contribution of the partners’ capital contribution
to the partnership's profit generating-capacity. The use of
interest on capital as a means of allocating profits would be
appropriate when the business is capital intensive versus labor
intensive or if the partners were not significantly involved in the
day-to-day operations.
Interest on Capital as a Distribution/Allocation of Net Income.
Using interest allowances on partners' capital accounts as a
technique for sharing partnership profit equitably has no effect on
the measurement of net income or loss of the partnership.
Remember that the partners' capital contributions are just that -
they are not loans to the partnership. Accordingly, it is not
appropriate to charge an Interest Expense account and an
Interest Payable account, because interest on partner's capital
account is not an expense of the partnership.
Some partnerships do record imputed interest in this manner,
although, not technically correct, it does not affect the final profit
and loss allocations. Eventually, any remaining balance in the
Interest Payable account at year-end is then transferred to the
partner account.
Another item of expense arising from dealings between a
partnership and one of its partners is commonly encountered when
the partnership leases property from a lessor who is also a
partner. Rent expense is recognized by the partnership.
Assume that X and Y agree to allow interest on average capital at
6%; any net income or loss balance is to be allocated 3:7. Assuming
no entries for interest during the course of the year, entries to record
the allowance of interest and the remaining allocation of net income
follow:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,700
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,300
X's interest on average capital: 6% of P345,000. . . . . . . P 20,700
Y's interest on average capital: 6% of P405,000. . . . . . . 24,300
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 45,000

9
 .

Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243,000

X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,900
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170,100
X Y Total
Interest on average capital P 20,700 P 24,300 P 45,000
Balance (3:7) . . . . . . . . . . . . . . 72,900 170,100 243,000
Total . . . . . . . . . . . . . . . . . . . . . . P 93,600 P 194,400 P 288,000

The allocation of net income may be summarized in a single entry as

follows:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,600
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194,400

Interest on Capital Accounts with Resultant Net Loss

If the partnership contract provides for allowing interest on
capital accounts, this provision must be enforced regardless of
whether operations are profitable or unprofitable.
The only justification for omitting the allowance of interest on
partners' capital accounts during a loss year would be in the case of
a partnership contract containing a specific provision requiring such
omission. After the entry for interest in such a case, the debit
balance in the income summary account is transferred to the
partners' drawing accounts in the profit-and-loss ratio.
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 for the distribution of the
balance after allowance of interest.
Further, when the partnership agreement also 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.
For example, assume that operations for X and Y prior to the
recognition of interest had resulted in a net loss of P80,000 and any
balance will be allocated into 1:4 ratio.
Entries to close the income summary account would have been as
follows:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000
10
 X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,700
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,300
X's interest on average capital: 6% of P345,000. . . . . . . P 20,700
Y's interest on average capital: 6% of P405,000. . . . . . . 24,300
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 45,000
.

X, 25,000
drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Y, 125,000
drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . .

The net effect of the foregoing on capital is:

X Y Total
Interest on average capital P 20,700 P 24,300 P 45,000
Balance (3:7) . . . . . . . . . . . . . . (25,000) (100,000) 243,000
Total . . . . . . . . . . . . . . . . . . . . . . (P 4,3000) (P 75,700) (P 80,000)

The allocation of net income may be summarized in a single entry as

follows:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,700
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,300

Partners can provide by agreement that net income or loss shall be

allocated in some arbitrary manner without recognition of interest
when the results from operations fail to cover a specified interest
allowance.
Interest on Excess Capital Balance. It may be agreed to allow
interest on the excess of the average capital of one partner over that
of another. If these were the agreement between X and Y, the entry to
record interest and the balance in net income assuming 1:2 ratio is:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600

Y’s interest on excess average capital:

6% of (P405,00 - P345,000) . . . . . . . . . . . . . . . . . . . . . 3,600

Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284,400

X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,800
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189,600

X Y Total
11
 Interest on average capital P 3,600 P 3,600
Balance (3:7) . . . . . . . . . . . . . . P 94,800 189,600 284,400
Total . . . . . . . . . . . . . . . . . . . . . . P 94,800 P 193,200 P 288,000
The allocation of net income may be summarized in a single entry as
follows:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,800
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193,200

Interest on temporary advances or loans. When a partnership makes

a temporary advance to a partner or receives an amount as a
temporary loan from a partner and these transactions are
recognized as creating debtor - creditor relationships between the
partner and the partnership, interest charges and credits on such
transactions are recognized as interest-expense-interest-income.
Interest accruals are recognized periodically on these items just as
other receivable and payable balances. When settlement for interest
is made by cash, entries to record the collection of interest or the
payment of interest are made in the usual manner.
When settlement is not to be made in cash but by adjustments to
partners' capitals, Interest on an advance to a partner is recorded by
a charge to the partner's drawing account and a credit to Interest
Income, interest on a loan made by a partner to the partnership by a
charge to Interest Expense and a credit to the partner's drawing
account.
In summary, interest on loans from partners is recognized as
expense and as a factor in the measurement of net income or loss of
the partnership. Similarly, interest earned on loans is recognized as
partnership revenue. This is consistent with the principle that loans
from partners are assets and liabilities, respectively.
Personal Services Rendered in Net Income and Loss
Partners may wish to provide for an allocation of net income that
recognizes differences in their abilities and experience or in the time
devoted by them to business. Partners may agree to an arbitrary
ratio for this purpose.
However, the use of an arbitrary ratio to recognize personal
differences is subject to the same limitations as those found in
the use of the capital ratio to recognize capital differences; i.e.. it
may fail to provide satisfactory recognition of the several factors
contributing to the success of the partnership and it may prove
12
inequitable in the event of loss when the partner who has made the
greater personal contribution to the Partnership is charged with the
greater part of the loss.
Salary Allowances
In recognizing differences in personal contribution as well as
other factors that are responsible for the success of the
partnership, it may be agreed that partners shall be allowed
salaries, with any net income or loss balance after salaries divided
in some arbitrary ratio. Philippine partnership law makes no
provision for remuneration for Partner's services in the absence of
an agreement, so it is up to the partners to agree on what is just and
fair compensation.
A partner who devotes time to the partnership business while the
other partners work elsewhere may receive a salary allowance.
Salary allowances are also used to compensate for differences in
the fair value of the talents for partners, all of whom devote their
time to the partnership.
The purpose of salary allowances are means of achieving a fair
division of profit among the partners based on the time and
talents devoted to partnership business. Salaries to partners are
often included, as part of the profit distribution plan to recognize
and compensate for differing amounts of personal services partners
provide to the business
Following are the reasons why salaries cannot be treated as expense
of the partnership:
1. It is important to note that this treatment of partner's salaries
differs from the treatment of employee/shareholder salaries of
a corporation. Calculating partnership income after salary
allowances is proper when comparing the performance of a
partnership business with similar businesses operated under
the corporate structure.
2. Calculation of partnership' income after salary allowances is
likewise proper in assessing the success of a business. The
financial success of a partnership business lies in its earning a
fair return for the services performed by partners, for capital
invested in the business, and for the risks taken.
To illustrate the effect of a salary arrangement, assume that X and Y
agree to the allowance of monthly salaries of P10,000 and P9,000,
respectively; any net income or loss balance to be allocated in the

13
ratio of beginning capital. Amounts actually withdrawn by partners
during the year were recorded in their drawing accounts as
presented in the original problem. The net income of P288,000
before recognition of salaries is allocated to the partners by the
following entries:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000
X: Salary for 12 months at P10,000 per month . . . . . . . P 120,000
Y: Salary for 12 months at P9,000 per month . . . . . . . . . 108,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 228,000
.

Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

The net effect of the foregoing on capital is:

X Y Total
Interest on average capital P 120,000 P 108,000 P 45,000
Balance (3:7) . . . . . . . . . . . . . . 25,000 35,000 243,000
Total . . . . . . . . . . . . . . . . . . . . . . P 145,000 P 143,000 P 288,000

The allocation of net income may be summarized in a single entry as

follows:
Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288,000
X, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145,000
Y, drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143,000

A general precept of partnership accounting is that salaries to

partners are not expenses in the determination of partnership net
profit but are part of the allocation plan. This precept is closely
related to the proprietary concept of owner's equity 'as discussed in
Chapter 19. According to the proprietary theory, the proprietor
contributes capital and personal services in pursuit of profit. The
profits are the results of those twc Investments.
The same logic applies to the partnership form of organization.
Some partners contribute capital while others contribute personal
time. Those who contribute capital are typically rewarded with
interest on their capital; those who contribute personal time are
rewarded with salaries.

14
Similarly situated with Interest on Capital discussed above, partners
are owners, not employees. It is not appropriate to charge a Salary
Expense account and credit Salary Payable.
Some partnerships do record salary allowances in this manner,
although, not technically correct, it does not affect the final profit
and loss allocations. Eventually, any remaining balance in the
Accrued Salary Payable account at year-end is then transferred to
the partner account.
However, both interest and salaries are results of the respective
investments that are used not in the determination of income but
rather as an allocation of profit.
Salary Allowances with Resultant Net Loss
When an agreement provides for salaries without qualification,
salary allocations must be made even though profit is
inadequate to cover salaries or there is a loss. After salaries are
recorded, the income summary account shows a debit balance that
is transferred to the partners’ accounts as agreed.
Bonuses
Bonuses are sometimes used as a means of providing additional
compensation to partners who have provided services to the
partnership. Bonuses are typically stated as percentage of profit
either before or after the bonus.
In the absence of any agreed basis, bonus is computed on the
basis of partnership net Income and the concept of "partnership
net income" is generally understood in accounting practice (i.e.,
before bonuses are deducted.)
However, partnership agreement should be precise in specifying the
measurement procedures to be used in determining the amount of
the bonus.
As with interest on capitals and salary allowances, a bonus should
be considered as a distribution of profit and not to be charged to an
expense account.
Sometimes the partnership agreement requires a minimum profit to
be earned before bonus is calculated.
Illustration 18-2: Allocation of Net Income with Bonus.
The net income of A and B Partnership for 20x4 amounted to
P420.000. A, as the managing partner, is allowed as a bonus based
on the following assumptions:
15
 A. A bonus of 20% of net income before the bonus is
deducted, the bonus would be computed as follows:
Let B = Bonus
B = 20% of Net income
B = 20% of 420,000
B = P84,000
B. B. A bonus of 20% of net income after deduction of the
bonus, the bonus computed as follows:
Let B = Bonus
B = 20% of Net income after Bonus
B = 20% (420,000-B)
B = P84,000 - 0.20B
1.20 = P84,000
B = P70,000
As a B 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

Basis of Computation for Bonus

As long as the basis of computation for bonus will be a positive
amount, the resulting bonus should always be allocated to partners
entitled to it, regardless of the availability of the residual amount.
Illustration 18-3: Allocation of Net Income with Bonus, Salaries,
Interest and Income tax.
Refer to Illustration 18-2, assume that the partners further agreed
on the allocation of net income:
 Bonus of 20% to A:
 Salaries to A, P40,000 and B. P60,000:
 Interest on average capital balances-A, P12,000 and B, P8,000.
 Residual balance in net income be allocated to A and B in the
ratio of 2:1 ratio.
The following assumptions for bonus are considered:
1. Bonus is based on net income before bonus, salaries and
interest - same as Illustration 18-2 (A).
The schedule showing the allocation of net income is presented as
follows
A B Total
Bonus . . . . . . . . . . . . . . . . . . . . . P 84,000 P 84,000
Salaries . . . . . . . . . . . . . . . . . . . 40,000 P 60,000 100,000
. 12,000 8,000 20,000
Interest . . . . . . . . . . . . . . . . . . . 144,000 72,000 216,000
16
 . P 280,000 P 140,000 P 420,000
Balance (2:1) . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . .

2. Bonus is based on net income after bonus but before

salaries and interest - same as Illustration 18-2 (B).
The schedule showing the allocation of net income is presented as
follows:
X Y Total
Bonus . . . . . . . . . . . . . . . . . . . . . P 70,000 P 70,000
Salaries . . . . . . . . . . . . . . . . . . . 40,000 P 60,000 100,000
. 12,000 8,000 20,000
Interest . . . . . . . . . . . . . . . . . . . 153,333 76,667 230,000
. P 275,333 P 144,667 P 420,000
Balance (2:1) . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . .

3. Bonus is based on net income after bonus and salaries but

before interest:

Let B = Bonus; S = Salaries; and I = Interest.

B = 20% of Net income after Bonus and Salaries before Interest
B = 20% (P420,000 - B - S)
B = 20% (P420,000 – B - P100,000)
B = 20% (P320,000-B)
B = P64,000-.20B
1.20B = P64,000
B = P53,333

Note: It should be noted that the term "before" used in the allocation of net
income particularly in the computation of bonus does not give any sense at all
because the general rule as to the interpretation of "net income" means it is
before deduction of bonus, salaries to partners and interests on capital. These
three elements (bonus, salaries to partners and interest on capital) of allocation
of net income are not expenses of the partnership but merely as a distribution or
allocation of net income.
Proof:
Net income before bonus, salaries and interests P 420,000
Less: Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,333
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Net income after bonus, salaries before interests P 266,667

17
 Multiplied by: Bonus rate . . . . . . . . . . . . . . . . . . . . . . . _ 20%
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 53,333
The schedule showing the allocation of net income is presented as
follows:
A B Total
Bonus . . . . . . . . . . . . . . . . . . . . . P 53,333 P 53,333
Salaries . . . . . . . . . . . . . . . . . . . 40,000 P 60,000 100,000
. 12,000 8,000 20,000
Interest . . . . . . . . . . . . . . . . . . . 164,445 82,222 246,667
. P 275,333 P 144,667 P 420,000
Balance (2:1) . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . .
4. Bonus is based on net income after bonus, salaries and
interest:
Let B = Bonus; S = Salaries; and I = Interest.
B = 20% of Net income after Bonus, Salaries and
B Interest
B = 20% (P420,000 – B – S - I)
B = 20% (P420,000 – B - P100,000 - P20,000)
B = 20% (P300,000 - B)
1.20B = P60,000-.20B
B = P60,000
= P50,000

Proof:
Net income before bonus, salaries and interests P 420,000
Less: Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Net income after bonus, salaries before interests P 250,000
Multiplied by: Bonus rate . . . . . . . . . . . . . . . . . . . . . . . _ 20%
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 50,000

The schedule showing the allocation of net income is presented as

follows:
A B Total
Bonus . . . . . . . . . . . . . . . . . . . . . P 50,000 P 50,000
Salaries . . . . . . . . . . . . . . . . . . . 40,000 P 60,000 100,000
. 12,000 8,000 20,000
Interest . . . . . . . . . . . . . . . . . . . 166,667 83,333 250,000
. P 268,667 P 151,333 P 420,000
Balance (2:1) . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . .

18
 5. Bonus is based on net income after salaries but before

Let B = Bonus; S = Salaries; and I = Interest.

B = 20% of Net income after Salaries before Bonus and Interest
B = 20% (P420,000 - S)
B = 20% (P420,000 - P100,000)
B = 20% (P320,000)
B = P 64,000
bonus and interest:

6. Bonus is based on net income after interest but before

bonus and salaries
Let B = Bonus; S = Salaries; and I = Interest
B = 20% of Net income after Interest, before Bonus and
B Salaries
7. B B o= 20% (P420,000
n u- P20,000)
s i s b
B = 20% (P400,000)
= P80,000
income tax (tax rate is 35%):
Let B = Bonus;
B = 20% (P420,000 - 147,000 )
B = P54,600

Let T = Income tax

T = 35% (P420,000)
T = P147,000

Proof:
Net income before bonus and income tax . . . . . . . . . P 420,000
Less: Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,600
Net income after bonus before income tax . . . . . . . . P 365,400
Less: Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147,000
Net income before bonus and income tax . . . . . . . . . P 218,400
Bonus as computed above:
Net income before bonus and income tax . . . . . . . . . P 420,000
Less: Income tax (35% x 147,000
P420,000) . . . . . . . . . . . . . . . P 273,000
Net income after income tax before bonus . . . . . . . . _ 20%
Multiplied by: Bonus rate . . . . . . . . . . . . . . . . . . . . . . . . P 54,600
Net income after income tax and bonus. . . . . . . . . . .
8. Bonus is based on net income, that is, after bonus and
Income tax

19
 Let B = Bonus; T = Income tax
B = 20% (P420,000 - B – 147,000)
B = P54,600 – 0.20B
1.2B = P54,600
B = P45,500

Let T = Income tax

T = 35% (P420,000)
T = P147,000

Proof:
Net income before bonus and income tax . . . . . . . . . P 420,000
Less: Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,500
Net income after bonus before income tax . . . . . . . . P 374,500
Less: Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147,000
Net income before bonus and income tax . . . . . . . . . P 227,500
Bonus as computed above:
Net income after income tax before bonus . . . . . . . . P 227,500
Multiplied by: Bonus rate . . . . . . . . . . . . . . . . . . . . . . . . _ 20%
Net income after income tax and bonus. . . . . . . . . . . P 45,500

Bonus with Resultant Net Loss

The concept of bonus is not applicable to a net loss. When a
partnership operates at a loss, the bonus provision is disregarded
because it defeats the purpose of giving bonus.
Insufficient Income to Cover Allocation
In some cases, the partnership net income may be less than the
interest, salary and/or bonus provided for in the partnership
agreement.
If the partners fail to provide for such an occurrence in the profit
and loss formula, the established practice is to allocate the
interest, salary and/or bonus as if sufficient income had been
earned. The amount by which the interest, salary and/or bonus
exceeds the net income is allocated to the individual partners in
their agreed ratio for allocating residual income.
Therefore, it is simply satisfying all provisions of the profit and loss
agreement. This procedure should also be followed when the
partnership has an overall loss (see previous discussion on interest,
salary and bonus with a resultant net loss).
Special Problems in Allocation of Profit and Loss - Salaries and
Interest as an Expense

20
In the previous discussions, net income was viewed as the return
to the partners for their full contribution to the business as
owners - capital as well as personal service. Interests and salary
allowances to partners were regarded as a means of providing
for an equitable distribution of such income.
It is possible to record salaries and interest as part of expense
items rather than as distribution or allocation of net income.
When these items are made to expense accounts rather than to the
partners' drawing accounts (or capital accounts): expense balance
are then closed into the Income Summary account in arriving at the
net income to be allocated in the agreed profit and loss ratio.
On the income statement, partners' interest and salaries would be
listed with the other expenses in arriving at net income or loss of the
partnership.
Whether partners' interest and salaries are treated in the accounts
as expense items or as distributions or allocation of net income, the
eventual distribution or allocation of partnership net income or loss
among the partners remain exactly the same.
Corrections of Partnership Net Income of Prior Period
Errors may occur in accounting for partnership operations, such as
failure, to accrue or defer expenses or revenue errors in the
inventory count or pricing, or errors in the calculation or
amortization of assets.
Problems in the allocation of profit and loss can result if (1) errors
are discovered that occurred in specific prior years, and (2) the
partners have altered the profit and loss agreement since the period
in which the error occurred. In corporation, an error correction is
accounted for as an adjustment to the beginning retained earnings
balance.
However, in a partnership the correction is allocated to the
individual partners' capital accounts. The allocation should be based
on the profit and loss agreement in effect during the period of the
error.
Subsequent Changes in Methods to Allocate Net Income or Loss
If the partners subsequently agree to change the method to allocate
profit and losses, equity dictates that assets be revalued to their
current values at the time of the change.

21
For example, assume that partners X and Y shared profits and losses
in a 6:4 ratio respectively, but at a later date agreed to share profits
and losses equally. Suppose that the partnership holds a piece of
machinery carried on the books at P100,000, but with a P140,000
current value. Partner Y would receive a larger share of the profit on
the machinery (when it is later sold) than had the machinery been
sold before the change in the method to share profits and losses
were shared 6:4 ratio.
As an alternative to revaluing the machinery to its current value to
stipulate in the new profit-sharing formula that the first P40,000 of
profit on the sale of that machinery is to be shared in the old profit
and loss sharing ratio.
When the profit and loss sharing formula 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 as follows:
Under this method, the partnership avoids making an entry that is
different with what is Generally Accepted Accounting Principles
(GAAP). This is not a major reason for selecting this alternative,
however, if revaluing assets is more practical.
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.
Regardless of the fact that some of these items do not quality as
prior period adjustments greater equity is usually achieved among
the partners by using the old sharing formula. Because partnerships
need not follow GAAP, the will of the partners may prevail.
Special Profit Allocation Methods
Some partnerships distribute net income on the basis of other
criteria. For example, most public accounting partnerships
distribute profit:
1. On the basis of partnership "units". A new partner may
acquire a certain number of units, and additional units are
assigned by a partnership compensation committee for

22
 obtaining new clients, or for providing the firm with specific
areas of industrial expertise.
2. Performance methods. It gives some weight to the specific
performance of each partner to provide incentives to perform.
a. Chargeable hours. These are the total number of hours
that a partner incurred on client-related assignments.
Weight may be given to hours in excess of normal,
b. Total billings. The total amount billed to clients for work
performed and supervised by a partner constitutes total
billings. Weight may be given to billings in excess of
normal,
c. Write-offs. Write-offs consist of the amount of
uncollectible billings. Weight may be given to a write-off
percentage below normal.
d. Promotional and civic activities. Time devoted to
developing future business and enhancing the partnership
name in the community is considered promotional and
civic activity. Weight may be given to time spent in excess of
normal or to specific accomplishments resulting in new
clients.
e. Profits in excess of specified level. Designated partners
commonly receive a certain percentage of profits in excess
of a specified level of earnings.
Statement of Changes in Partners' Capital Accounts
The balance sheet and income statement for a partnership are
accompanied by a third statement that reports the changes that have
taken place in the partners' interests during the period. The
statement of changes in partners' capital accounts based on
Illustration 18-1 (assuming that 6% interest is based on average
capital with the remaining net income be allocated based on a 3:7
ratio for X and Y, respectively) may be prepared in the following
manner:
X and Y Partnership
Statement of Changes in Partner's Capital Accounts
For the Year Ended, December 31, 20x4
X Y Total
Capitals, January 1, P 300,000 P 420,000 P 720,000
20x4 . . . . . . . . . . . . . . . . _ 60,000 _ 60,000 _ 120,000
Add: Additional P 360,000 P 480,000 P 840,000
Investments . . . . . . . . . . . . _ -0- _30,000 _30,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 360,000 P 360,000 P 810,000
Less: Capital 93,600 194,400 288,000

23
withdrawals . . . . . . . . . . . . . . . P 453,600 P 644,400 P 1,098,000
Ending Capital before Net _ 36,000 114,000 150,000
Income . . . . . . . P 417,600 P 530,400 P 948,000
Add: Net Income (see
schedule) . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Personal withdrawals . . . . . . . . . . . . .
Capitals, December 31, 20x4 . . . . . . . . . . . .

X and Y Partnership
Schedule - Allocation of Net Income
For the Year Ended, December 31, 20x4
X Y Total
Interest on average capital P 20,700 P 24,300 P 45,000
Balance (3:7) . . . . . . . . . . . . . . 72,900 170,100 243,000
Total . . . . . . . . . . . . . . . . . . . . . . P 93,600 P 194,400 P 288,000

24