CHAPTER 1: PARTNERSHIP III.

DIVISION OF PROFITS AND LOSSES

I. INTRODUCTION As a rule, profits and losses are allocated based

on agreement.
A PARTNERSHIP is defined as an
association of two or more persons who contribute Methods - Various methods exist for the
money, property or industry to a common fund DIVISION OF PARTNERSHIP PROFITS AND
with the intention of dividing the profits among LOSSES including the following:
themselves. 1. Equally
Accounting for partnerships should comply 2. Arbitrary ratio
with the legal requirements as set forth by the 3. Capital contribution ratio:
Partnership Law as well as complying with the a. Original Capital or initial investment
partnership agreement itself. b. Beginning Capital of each year
C. Average Capital
II. PARTNERSHIP FORMATION AND CAPITAL d. Ending Capital of each year
ACCOUNTS 4. Interest on capital balance and/or loan
balances and the balance on agreed ratio,
All assets contributed to the partnership 5. Salaries to partners and the balance on
are recorded by the partnership at their agreed agreed ratio,
values (or fair market values, in the absence of 6. Bonus to partners and the balance on
agreed values). agreed ratio,
All liabilities that the partnership a. Bonus as an "expense" in computing the
assumes are recorded at their net present bonus amount. Here, bonus is computed
values. Thus, if a partner contributes a noncash based on net income after bonus.
asset to the partnership (e.g. land or equipment b. Bonus as a distribution of profit. Here,
subject to mortgage), the Contributing partner's the bonus is computed based on net
capital account is credited for the agreed value income before deducting the bonus.
(or fair values) of the noncash asset less the 7. Interest on capitals and/or loan balances,
mortgage assumed by the partnership. salaries to partners, and bonus to partner and
The capital account is an equity account the balance on agreed ratio.
similar to the shareholders' equity accounts in a The method of division to be used in any
corporation. It is used to account for permanent given situation is generally the method
withdrawals and additional contributions. specified in the partnership agreement.
Other important accounts include a This agreement must always be consulted first
drawing account and loans to or from partners. since it is legally binding on the partners.
The drawing account is used to account If no profit and loss sharing arrangement
for net income or loss and personal or normal is specified in the partnership agreement, the
withdrawals, i.e., share against net income. It is partnership requires that profits and losses be
closed at the end of the period into the capital shared according to capital contribution.
account. Capital contribution should be
Loan accounts are set up for amounts interpreted to be original capital/beginning
intended as loans, rather than as additional capital capital of each year in the absence of original
investments. In liquidation proceedings, a loan to capital; similarly, if the agreement specifies
or from a partner is in essence treated as an how profits are to be shared but is silent as to
increase or decrease in a partner's capital account. losses, losses are to be shared in the same
manner as profits.
 Notice that the profit and loss sharing ratio Total capital equals the book value of the
is totally independent of the partners' net assets prior to admittance of the new partner,
ownership interests. Thus, two partners may plus the FMV of the assets contributed by the new
have ownership interests of 70% and 30% but partner.
share profits and losses equally. A difference between the FMV of the
assets contributed and the interest granted to
IV. DISSOLUTION the new partner results in the RECOGNITION of
a BONUS.
A. Admission of a New Partner
a. No bonus recognized - When an incoming
A new partner may be admitted to the partner's capital account (ownership
partnership by purchasing the interest of one or interest) is to be equal to his purchase
more of the existing partners or by contributing price, the partnership books merely debit
cash or other assets (i.e., investment of cash or other assets and credit capital.
additional capital). These two situations are b. Bonus granted to the old partners - When
discussed below. the FMV of the assets contributed by an
incoming partner exceeds the amount of
1. Purchase of interest - When a new partner ownership interest to be credited to his capital
enters the partnership by purchasing the account, the old partners recognize a bonus
interest of an existing partner, the price paid equal to this excess.
for that interest is irrelevant to the This bonus is allocated on the basis of the
partnership accounting records because it is same ratio used for income allocation
a private or personal transaction between (unless otherwise specified in the partnership
the buyer and seller. The assets and agreement). Recording involves crediting the old
liabilities of the partnership are not affected. partners' capital accounts by the allocated
The capital account of the new partner is amounts.
recorded by merely reclassifying the capital c. Bonus granted to new partner - An incoming
account of the old partner. partner may contribute assets having a FMV
smaller than the partnership interest granted
2. Admission by Investment of Additional to that new partner.
Assets - A new partner may be granted an
interest in the partnership in exchange for Similarly, the new partner may not contribute
contributed assets and/or goodwill (e.g., any assets at all. The incoming partner is
business expertise, an established clientele, therefore presumed to contribute an intangible
etc.). The admission of the new partner and asset, such as managerial expertise or personal
contribution of assets may be recorded on business reputation. In this case, a bonus is
the basis of the bonus method. granted to the NEW partner, and the capital
accounts of the OLD partners are reduced on
*Bonus method - This method is based upon the the basis of their profit and loss ratio.
historical cost principle.
*Goodwill method. In PFRS No. 3, goodwill
Admittance of a new partner involves represents the excess of the cost of the business
debiting cash or other assets for the FMV of the combination OVER the fair value of the
assets contributed and crediting the new partner's identifiable net assets obtained.
capital for the agreed (i.e., purchased)
percentage of total capital. Therefore, the standard provides that
goodwill attaches only to a business as a whole
and is recognized only when a business is
acquired. This provision of PFRS No. 3 outlawed 1. Selling of an interest to an outsider. This is
the use of the goodwill method in partnership similar to admission by purchase.
accounting, particularly admission and retirement 2. Selling of an interest to an existing partner. The
of a partner because there is no business involved. interest of the retiring partner will be purchased
The term "business" is defined in the Appendix A with the personal assets of existing partners rather
of PFRS No. 3 as: than with the assets of the partnership.
An integrated set of activities and assets 3. Selling of an interest to the
conducted and managed for the purpose of partnership/payment from partnership fund.
providing: Under this approach, the withdrawal of a partner
maybe treated as:
(a) a return to investor, or
(b) lower costs or other economic benefits directly a. Payment at book value
and proportionately to policyholders or b. Payment at less than book value- bonus method
participants. c. Payment at more than book value - bonus
method
A business generally consists of inputs,
processes applied to those inputs, and resulting C. Incorporation of a Partnership
outputs that are, or will be used to generate
revenues. If goodwill is present in a transferred For a variety of reasons, including legal and/or tax
set of activities and assets, the transferred set reasons, the partners of a partnership may choose
shall be presumed to be a business. to incorporate.

B. Withdrawal of a Partner Two approaches of opening the corporate books

are in general use.
Admission of a new partner is not the only manner
by which a partnership can undergo a change in One is to retain the books of the partnership and
composition. Over the life of any partnership, to record all assets and liabilities at fair market
partners may leave the organization. Thus, some value concomitant with the closing of the partners'
method of establishing an equitable settlement of capital accounts and the opening of a Common
the withdrawing partner's interest in the business Stock account.
property is necessary.
The other approach is to close out the partnership
For a partner to withdraw or retire from the books completely and to open a new set of books
partnership, the total interest of a partner should for the corporation. In this case, the fair market
be properly determined which includes the values are used as the basis for recording all
following: assets and liabilities with the balancing amount
credited to Common Stock. Occasionally,
1. Share in the profit and loss of the partnership. additional cash or other assets may be invested in
2. Adjustments in assets and liabilities to reflect the corporation.
fair market values.
3. Loans to and from partnership. V. LIQUIDATION
4. Drawing accounts, and
5. Capital interest / accounts. Liquidation is the process of converting
partnership assets into cash and distributing the
Withdrawal or retirement from the partnership cash to creditors and partners.
may either be:
Frequently, the sale of assets will not provide
sufficient cash to pay both creditors and partners. Therefore, under this so-called right of offset
doctrine, a partner's loan to the partnership will
The creditors have priority on any distribution. have distribution priority only to the extent it
exceeds a debit balance in the partner's capital
The basic rule is that no distribution is made to account.
any partner until all possible losses and liquidation
expenses have been paid or provided for. An B. Installment Distributions - The
individual prematurely distributing cash to a liquidation of a partnership may take place over a
partner whose capital account later shows a deficit period of several months.
may be held personally liable if the insolvent
partner is unable to repay such a distribution. Installment distributions may be made to partners
on the basis of a Schedule of Safe Payments or
The proceeds of a liquidation may be distributed in Cash Priority Program, in conjunction with a
a lump sum after all assets have been sold and all Liquidation Schedule similar to the one used for
creditors satisfied, or the proceeds may be lump sum liquidations.
distributed to partners in installments as excess
cash becomes available. The Schedule of Safe Payments takes a
conservative approach to the distribution by
A. Lump Sum Distribution - The first step in assuming that noncash assets are worthless; thus,
the liquidation process is to sell all noncash assets distribution may be made to partners on the basis
and allocate the resulting gain or loss to the capital of the value of partnership assets, until the assets
accounts of the partners in accordance with their are sold.
profit and loss sharing ratio.

The second step is to satisfy the liabilities owing to

creditors other than partners.

The third step is to satisfy liabilities owing to

partners other than for capital and profits.

The final step is to distribute any cash remaining

to the partners for capital and finally for profits.

Any deficiency (i.e., debit balance) in a solvent

partner's capital will require that partner to
contribute cash equal to the debit balance.

If the deficient partner is insolvent, the debit

balance must be absorbed by the remaining
partners (usually in accordance with their profit
and loss sharing ratio).

Note, however, that in order to achieve an

equitable distribution, a partner's loan to the
partnership will first be used to offset a debit
balance in his capital account.