METHODS OF DISTRIBUTING PROFITS BASED ON PARTNERS' AGREEMENT

1. Equally - it is simple to apply but does not give due recognition on the disparity of capital contribution
nor does it recognize the time and effort that a partner may devote in running the firm's business,
2. 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.
3. According to 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.
4. 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 a partner may devote
in running the firm's business, Interest is allowed to partners for the use of invested capital. Interest as
agreed by partners shall be allowed in proportion to the period such capital was actually used, whether
the income is sufficient or insufficient or there is net loss, unless otherwise agreed upon by the
partners.
5. 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 but does not take into
consideration the differences in capital contributions.
Salaries are allowed to partners as compensation for their time devoted in the business. Salaries as
agreed by partners shall be allowed in proportion to the period the partners actually rendered services
to the firm. Such salaries shall be provided, whether the income is sufficient or not or there is a net
loss, unless otherwise agreed upon by the partners.
6. Bonus to managing partner and the balance on agreed ratio - this method allows bonus to the
managing partner as an incentive which is usually based on net income. Bonus. therefore, is allowed
only when there is sufficient net income. It may be computed using any one of the following as the
basis:
a) Bonus is based on net income before deducting bonus and income tax.
b) Bonus is based on net income after deducting bonus but before deducting income tax
c) Bonus is based on net income before deducting bonus but after deducting income tax.
d) Bonus is based on net income after deducting both bonus and income tax.
7. Interest on capital, salaries to partners, bonus to managing partner, and the balance on
agreed ratio.

Illustrative Problem A:
The following data are available in the books of Alice and Louella Partnership for the year 2001.
Alice, Capital Dr Cr
May 1 10,000 Jan 1  Balance 250,000
Apr 1 25,000
Oct 1 50,000
 
Alice, Drawing Dr Cr
Jan 1 - Dec 31 30,000
 
Louella, Capital Dr Cr
June 1 15,000 Jan 1 Balance 150,000
Dec 1 5,000 Sept 1 50,000
 
Louella, Drawing Dr Cr
Jan 1 - Dec 31 22,500
 
Income Summary Dr Cr
Dec 31 60,000
 
Twelve cases will be illustrated using the given data.
Cases 1-10 will show sufficient income, Case 11 will show insufficient income, and Case 12 shows a net loss.

Case 1
Net income is divided equally
 Income Summary      60,000
            Alice, Capital                     30,000
            Louella, Capital                  30,000
              P60,000 +2 = P30,000

Case 2
Net income is divided 3/4 and 1/4 to Alice and Louella
Income Summary           60,000
Alice, Capital 45,000
           Louella, Capital               15,000
                 P60,000 x 3/4
                P60,000 x ¼

Case 3
Net income is divided in the ratio of 1:4 to Alice and Louella.
Income Summary        60,000
        Alice, Capital                   12,000
        Louella, Capital                48,000
         P60,000 x 1/5 = P12,000
         P60,000 x 4/5 = P48,000

Case 4
Net income is allocated on the beginning capital ratio
Income Summary       60,000
         Alice, Capital                 37,500
        Louella, Capital              22,500
         250,000/400,000 x 60,000 
         150,000/400,000 x 60,000

Case 5
Net income is allocated on the ending capital ratio
Income Summary      60,000
         Alice, Capital                 38,182
        Louella, Capital             21,818
Alice Louella
Beg Capital 250,000 150,000
Additional Investment 75,000 50,000
Drawing (10,000) (20,000)
Ending Capital 315,000 180,000
315/495 x P60,000 =  P38,182
180/495 x P60,000 =    21,818

     It must be noted that withdrawals deducted for purposes of determining ending capital balances are the
debit entries in the capital accounts of each of the partners. These debit entries represent permanent
withdrawals or decreases on capital. The credit entries represent initial and/or additional investments.
     On the other hand, the debits to the drawing account represent temporary withdrawals or decreases in
capital caused by the in net loss (but may be debited directly to the capital account) or withdrawal of assets in
anticipation of profits. The credit entries represent increases in capital (may be credited directly to the capital
account) caused by the share in net income. The entries in the drawing accounts are not considered in
computing ending capital for the purpose of establishing the ratio.

Case 6 
Net income is allocated on the simple average capital
Beg + End / 2
Alice (250,000 + 315,000) / 2 = 282,500/447,500 x 60,000 = 37,877
Louella (150,000 + 180,000) / 2 = 165,000/447,500 x 60,000 = 22,123
Income Summary      60,000
      Alice, Capital                         37,877
     Louella, Capital                     22,123

Case 7
Net income is allocated on the average capital ratio
 Income Summary     60,000
      Alice, Capital                          38,129
      Louella, Capital                        21,871
        274,583/432,083 x P60,000 = P38,120
       157,500/432,083 x P60,000 =21,871
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, 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 represent peso months and divide the total by twelve (12) to obtain the average
monthly capital.

By following the steps given, the average capital for each of the partners can be calculated as follows:

Alice, Capital
Capital #of months Average
Period Peso months
Balance unchanged Capital
Jan 1 investment 250,000 3 750,000
Apr 1 inv 25k 275,000 1 275,000
May 1 draw 10k 265,000 5 1,325,000
Oct 1 inv 50k 315,000 3 945,000
12 3,295,000 274,583
Louella Capital
# of months Average
Period Capital Blance peso months
unchanged Capital
Jan 1 inv 150,000 5 750,000
June 1 draw 15k 135,000 3 405,000
Sept 1 inv 50k 185,000 3 555,000
1,890,000/12
Dec 1 draw 5k 180,000 1 180,000
= 157,500
 
274,583 + 157,500 = 432,083

Case 8
Each partner is allowed 10% interest on ending capital and the remaining income is divided
60%, 40%.
Income Summary        60,000
    Alice, Capital                          37,800
    Louella, Capital                      22,200

The distribution of profit may be recorded separately as follows:

Income Summary       49,500
                  Alice, Capital           31,500
         Louella, Capital        18,000
Income Summary      10,500
         Alice, Capital            6,300   
         Louella, Capital        4,200
Remaining income divided 60%, 40%.

Division of Net income:

Alice Louella Total
Interest on ending,
Capital
315,000 x 10% 31,500
180,000 x 10% 18,000 49,500
Remainder - 60%:40%
10,500 x 60% 6,300
10,500 x 40% 4,200 10,500
Total 37,800 22,200 60,000
 
Case 9
Louella is allowed salaries of P50,000 and the remaining income divided in the ratio of 1:4
Income Summary      60,000
                Alice, Capital            2,000
                Louella, Capital        58,000
Division of net income:
Alice Louella Total
Salaries 50,000 50,000
Remainder - 1:4
10,000 x 1/5 2,000
10,000 x 4/5 8,000 10,000
2,000 58,000 60,000

Case 10
Louella, the managing partner, is allowed a bonus of 20% of income BEFORE bonus and income
tax and the remainder is divided in the ratio of beginning capital.
Using the current income tax rate of 32%, the partnership income before income tax is P88,235, that is, net
income of P60,000 divided by 68%.

Income Summary                     60,000

       Alice Capital                                        26,471
       Louella Capital                                      33,529
Division of net income:
Alice Louella Total
Bonus - 88,235 x 20% 17,647 17,647
Remainder:
42,353 x 250/400 26,471
42,353 x 150/400 15,882 42,353
Total 26,471 33,529 60,000
Other assumptions on the computation of bonus shall be illustrated later in the chapter.

Case 11
The partners are allowed P500 and P 1,000 weekly salaries, respectively, 10% interest on
average capital, and the remainder is divided in the ratio of 2:3.
Income Summary       60,000
                     Alice, Capital           28,975
                     Louella, Capital       31,025
Division of net income:
Alice Louella Total
Salaries to partners
500 x 52 26,000
1000 x 52 52,000 78,000
Interest on average capital
274,583 x 10% 27,458
157,500 x 10% 15,750 43,208
Remainder
(61,208) x 2/5 (24,483)
(61,208) x 3/5 (36,725) (61,208)
Total 28,975 31,025 60,000
 
The sum of the salary allowance to partners and interest allowed on the average capital of the partners
exceeds the net income of P60,000 resulting in a negative remainder (loss). Such loss is distributed as
provided in the profit and loss sharing agreement.
Case 12
Assume the same agreement as in Case 11 except that instead of a net income, the partnership
has incurred a net loss of P10,000. –
The allowance for salaries and interest will still be provided, thereby resulting in a total loss to be
divided as agreed.
Louella, Capital                10,975
         Alice, Capital                   975
         Income Summary            10,000

Division of net income:

Alice Louella Total
Salaries to partners
P 500 x 52 P26,000
P 1,000 x 52 52,000 78,000
Interest on average
capital:
P274,583 x 10% 27,458
P157,500 x 10% 15,750 43,208
Remainder:
(131,208) x 2/5 (52,483)
(131,208) x 3/5 (78,725) (131,208) 
                                               975                          (10,975)                     (10,000)

Illustrations on the computation of bonus using other assumptions.

The same data in Illustrative Problem A shall be used. Bonus rate is 20%.

1. Bonus is based on income after deducting bonus but before deducting income tax,
B = .20 x (P88,235-B)
B = P17,647 - .20B
B + .20B = P17,647
B = P17,647/1.20
B = 14,706

2. Bonus is based on income before deducting bonus but after deducting income tax
B = .20 x (88,235 - B)
T = .32 x (88,235 -T)
Substituting for T in the first equation and solving for B:
.20 x (88,235 - P28,235)
.20 x P60,000
B = 12,000
Take note that the bonus was not deducted from the income subject to income tax. The bonus being
computed is not an expense but a distribution of net income after income tax.

3. Bonus is based on income after deducting both bonus and income tax.
B = .20 x (288,235 -B - T)
T = .32 x P88,235
    = P28,235
Substituting for T in the first equation and solving for B
B = .20 x (P88,235 - B - P28,235)
B = .20 x (P60,000 -B)
B = P12,000 - .20B
B + .20B = P12,000
B = 12,000/1.20
B = 10,000

In the preceding examples, bonus is treated as a distribution of partnership income, and therefore such bonus
is not deductible as an expense in determining the amount of taxable income. The same is true for salaries
and interest allowed on capital.

However, when such salaries, interests, and bonuses are treated as expenses rather than as distribution of
income, such are deductible as expenses in determining the amount of taxable income.
Illustrations on the computation of bonus when it is treated as an expense rather than as a distribution of
income are presented on the next page. The data used for the partnership of Alice and Louella will also be
used. Bonus rate is also 20%.

1.  Bonus is based on income before deducting bonus but after deducting income tax.
B =.20 (88,235 - T)
T = .32 (88,235 - B)
B = .20 [88,235 - .32(88,235 - B)]
B =.20[88,235 - 28,235 + .32B]
B = .20 (60,000 + .32B)
B = 12,000 + .064B
B - .064B = 12,000
.936B = 12,000
B = 12,000/.936B
B = 12,820.5 
 
2.  Bonus is based on income after deducting both bonus and income tax
B =.20 (88,235 - T - B)
T = .32 (88,235 - B)
B = .20 [88,235 -B -.32 (88,235 - B)]
B = 10,563