Advanced Financial Accounting and Reporting: Partnership Operation

PARTNERSHIP OPERATION

Introduction

There are a lot of possible scenarios that can be asked in partnership operation. There is no one
approach that you can use to all problems. As such, you need to expose yourself to different
problems (i.e., rule on maximum exposure) so as not to be easily overwhelmed. At a minimum,
you need the following in answering problems related to partnership operations:

1. English comprehension
2. Basic accounting (e.g., journal entries – adjusting vs. closing, types of accounts, basic
accounting equation)
3. Mathematics
a. Basic operation including PMDAS rule.
b. College algebra
c. Mathematics of investment (e.g., interest computation (Prt), present value
computation)
4. Rules provided by the Civil Code. This is also discussed in your RFBT.
5. Diligence, patience, eagerness, and right mental attitude in learning.

Primary accounting issues include:

a. Determination of profit or loss

b. Profit or loss allocation
c. Periodic adjustment of capital after operation

Determination of Profit or Loss

In computing the profit or loss, the transactional approach (revenue and gains less cost and
expenses) is normally used. However, for problem solving purposes, the problem may only
provide the beginning capital, ending capital and transactions that affects the capital. In this case,
profit or loss will be determined using the net asset or capital maintenance approach. Under the
capital maintenance approach, a profit is earned if the capital at the end exceeds the capital at the
beginning after excluding transactions with the owners (i.e., investment, drawings and withdrawal).
In some problems, the problem will provide the amount of profit or loss but with additional data on
errors. Such errors must be corrected to be able to compute the correct profit or loss. Computation
of profit or loss is ordinarily covered in Auditing and Assurance: Concepts and Application and
in Intermediate Accounting. As such, this chapter focuses on the distribution of profit or loss and
the determination of ending capital.

Note that formula in computing net income using the transactional approach is simply based on
closing entries discussed in your Basic Accounting.
Profit or Loss Division:

As provided in Article 1797 of the Civil Code, the losses and profits shall be distributed in
conformity with the agreement. If only the share of each partner in the profits has been agreed
upon, the share of each in the losses shall be in the same proportion.

In the absence of stipulation, the share of each partner in the profits and losses shall be in
proportion to what he may have contributed, but the industrial partner shall not be liable for the
losses. As for the profits, the industrial partner shall receive such share as may be just and
equitable under the circumstances. If besides his services he has contributed capital, he shall also
receive a share in the profits in proportion to his capital.

In summary, the following should be observed:

1. Profit Division
a. Profit sharing agreement
b. Original capital
2. Loss Division:
a. Loss sharing agreement.
b. How profit is divided.

For industrial partners, the following should be observed:

1. Profit Division
a. Profit sharing agreement
b. Just and equitable
2. Loss Division:
a. Loss sharing agreement, if any. Otherwise, he/she will not share.

Bonus, Interest and Salaries:

The partners may provide for the following methods of profit or loss distribution:

1. Salary – compensation for services; provided for regardless of the existence of profit
because the provision of services by a partner is independent from earning a profit.
a. Under proprietary theory, salaries given to a partner are a mere distribution of profit
or allocation of profit. In other words, salaries are not regarded as an expense.
b. Under the entity theory, the owners are considered separate from the business.
Hence, salaries given to a partner are considered partnership expense.
2. Interest – compensation for use of partner’s capital; provided for regardless of the existence
of profit because the use of the partner’s capital is independent from earning a profit.
Interest = Principal (i.e., Capital x Rate x Time)
3. Bonus – compensation for good performance. Performance can be based on financial or
non-financial measure. However, most of the question that you will encounter is based on
the net income which is a financial measure. If based on net income, bonus is provided only
when the partnership has profit and the base of the bonus is positive.
 Bonus bases:

a. Before bonus: Bonus = Bonus rate x bonus factor

b. After bonus: Bonus = Bonus rate x [bonus factor/ (100% + bonus rate)]

Note however that there is various base of bonus on which the partners may agree.

Special Allocation

1. Distribution of profit in order of priority. Profit can be distributed in order of priority agreed by
the partners. Order of priority or to the extent of earnings only is applicable only to profit and
not to losses.
2. Minimum profit sharing. The partners may stipulate that on or more partners will receive a
minimum profit share. As such, to satisfy the minimum of a partner, other partners must
share it in proportion to their remaining P&L ratio.
3. Bonus, interest and/or salaries are regarded as expense. Bonus, interest and/or salaries
can be regarded as partnership expense. However, this must be explicitly mentioned in the
problem. Accounting would differ as there are a lot of possible scenarios.

Profit or Loss Distribution Template

In distributing profit or loss, the following template should be used:

This template is used when salaries, interest and bonuses are distributed in any order and not
regarded as a partnership expense. However, this template should not be used if there is a special
profit-sharing agreement such as there is an order of priority or a minimum profit share.

Statement of Partner’s Capital

Beginning / Original Capital xx

Add: Additional investment xx
Less: Withdrawals (xx)
Less: Drawings (xx)
Add: Share in net income xx
Less: Share in net loss (xx)
Ending Capital xx

Note that the above formula is simply based on basic journal entries. Hence, students are
encouraged to always go back to journal entries before memorizing a formula.