In a sense averaging of capital is simply determining the average capital of a partner during the year because there are additional capital or withdrawal during year and that must be considered to get the real or effective capital status of a partner. To simplify, supposing , the beginnng capital is the basis for profit distribution . Supposing , during the year June 1 and additional capital of 10,000 was made and it remained uncheanged until dec 31, . The beginning capital is 5,000.00 last Jan 1. If you compute the profit share , 5,000 capital is the basis . , however if the average method is used, the capital base is 10,833.00 . this 10,833.00 is somewhat far from the 5,000.00 beginning capital hence the adoption of averaging..
the 3rd method is GIVING INTEREST AMOUNT USING A RATE BASED ON CAPITAL BALANCES, ( beg., end, averaging) AND THE REMAINDER of profit after deducting interest given IS ARBITRARY distributed..
This method implies that the partners will receive an amount called INTEREST on the basis of their capital. This amount is an initial share of the partner to the profit of the partnership. Most probably , this interest to be given to partners is small and there is a tendency that there will an excess of profit ater this interest is deducted and remaining profit will be shared arbitrarily.
In this method the following is to be agreed upon.
1. an agreement should provide for the amount or rate of interest.
2, the amount of capital either initial , beginning, average, ending which shall be the bases of the interest computation .
3. the procedure when a loss instead of profit has occurred .
4. or when the computed interest exceeds the income.
EXAMPLE: the profit to be shared is 20,000.00. PETE is entitled to 12 %, interest, TONY 10%. Their profit sharing is 60% Pete, 40% Tony. Say average capital is , PETE 80,000. TONY 50,000
pete tony
interest ( 12% x 80,000 ) 9600
interest (10% x 50,000 ) 5,000
remainder 60%x 5,400 3,240
remainder 40%x 5,400 ) 2160
total 12,840 7160 20,000
the 4th method is GIVING SALARY TO PARTNERS.
OR a combination of interest, salaries are also being practiced.
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LET ME SHIFT TO ANOTHER TYPE OF BENEFITS ACCORDED TO A PARTNER USING THE NET PROFIT AS THE BASIS AND THIS IS THE GIVING OF BONUS TO A PARTNER.
The bonus is either treated as an ordinary expense, or is treated as a distribution of profit to partners.
If it is treated as EXPENSE , the bonus is computed based on net profit after deducting that bonus or even after deducting interest and salary allowance..
If it is treated as DISTRIBUTION OF PROFITS then the bonus is computed based on net profit after deducting interest and salary.
The computation of bonus especially based on net profit after deducting that bonus or even after deducting interest and salaries, may to some, is a little bit difficult. So allow me to simply the algebraic expression being used by some teachers into a mathematical computation.
It is said that the bonus rate is to be multiplied to the NET PROFIT after DEDUCTING that bonus, sounds confusing.
HERE IS HOW:
If a certain percentage (bonus rate) is to be multiplied to NET INCOME after bonus , that NET INCOME after bonus is said or considered to be at 100% since it is on this 100% that the bonus rate will be multiplied . NOW , since this 100% is arrived at because the bonus was deducted from the NET PROFIT before bonus , therefore using work back approached , that is, NET INCOME AFTER BONUS is 100% , add the bonus rate, will equal the equivalent PERCENTAGE of the NET INCOME BEFORE BONUS.
REMEMBER THIS PRINCIPLE : ANY AMOUNT DIVIDED BY A PERCENT IT REPRESENTS THE ANSWER IS THE AMOUNT IN ITS 100%.
IN THIS BONUS COMPUTATION, THE BONUS RATE IS TO BE MULTIPLIED TO ITS BASE AMOUNT AND THIS AMOUNT IS REPRESENTED BY 100%. NOW SINCE THIS 100% WAS ARRIVED BECAUSE A BONUS RATE WAS DEDUCTED FROM THE NET INCOME BEFORE
BONUS, THEN THAT MEANS THE NET PROFIT BEFORE BONUS IS BY WAY OF WORK BACK IS . 100% PLUS BONUS RATE EQUALS THE PERCENT EQUIVALENT OF NET PROFIT BEFORE BONUS.
Now since we know the equivalent or representative percentage of the NET PROFIT BEFORE BONUS, you just simple divide the NET PROFIT BEFORE BONUS to its equivalent percentage , THEN YOU ARRIVE THE AMOUNT OF NET PROFIT AFTER BONUS , which is the 100%. So, you multiply now the rate of bonus to the NET PROFIT AFTER BONUS to get the BONUS AMOUNT to be given to the partner.
EXAMPLE.
BONUS IS 20% , NET PROFIT IS 200,000,
NET PROFIT 200,000 120%
less: bonus ?
__________________________________________20%_____________
NET PROFIT AFTER BONUS ? 100%
X 20%
Now dividing 200,000 net profit by its equivalent percentage, of 120%, the answer is 166,666.66 which is the 100% representing the NET PROFIT AFTER BONUS, multiply this by 20% , you get 33,333.33 as bonus. TO PROVE:
NET PROFIT 200,000.0O 120%
BONUS 33,333.33 20%
NET PROFIT AFTER BONUS 166,666.67 100%
X 20% 33,333.33 20%
of course, the 120% was arrived at by adding the 100% plus 20% equals 120%. hence 120% profit before bonus , less bonus of 20% equals 100%, where you now multiply the bonus rate.
a test or quiz or board exam might appear that the bonus amount and rate of bonus is given but the net profit is unknown. To solve it is: bonus divide 20% = profit after bonus PLUS BONUS AMOUNT = net profit before bonus.
Or the net profit after bonus is given and the rate of bonus, how much is the net profit.
There is another bonus computation that is also complicated to some. And this is the bonus is computed on net profit after bonus, after interest.
EXAMPLE : BONUS IS 20% FOR PETE, , INTEREST IS 10,000 PETE,, TONY 5,000
NET PROFIT IS 200,000.00
Computation:
net profit 200,000
less interest 15,000
net profit after interest 185,000
less: bonus ( 20%)
__________________________________________________________________
net profit after bonus and interest 100% which will be basis of the bonus rate.
x 20%
Now considering that the net profit after bonus and interest became 100% where it became 100% because a 20% bonus is deducted from the net profit after interest, therefore the 185,000 is represented by 120% ( 100% add 20%) . Dividing 185,000 by 120% , gives you 154,166.66 as the NET PROFIT AFTER BONUS AFTER INTEREST which will serve as basis of the 20% bonus of 30,833.33.
to prove:
net profit after interest 185,000
Less: bonus 30,833.33
net profit after interest/bonus 154,166.67 x 20% = 30,833.33
Now , the same formula if the salary allowance is also included. All you have to do is deduct the salary allowance to arrive at the NET PROFIT AFTER INTEREST AFTER SALARY ALLOWANCE. This net profit just mentioned will now be the amount that will be divided on a percentage arrived in adding 100% plus bonus rate. So if the bonus rate is 5%, the divisor would be 105%, if 30%, 130% so on so forth.
BUT SUPPOSING THE TOTAL OF BONUS, INTEREST , SALARIES IS BIGGER THAN THE NET PROFIT, WHAT WILL BE THE PROCEDURE.
In the preceeding example , supposing the profit is only 20,000.00. How is the distribution of profit if profit sharing is 60% pete, 40% tony. Bonus is 5%.
PETE TONY
INTEREST 10,000 5,000 15,000
SALARIES 3,000 8,000 11,000
bonus 833.33 833.33
TOTAL. 13,833.33 13,000 26,833.33
distribution of loss ( 4,100.00 ) ( 2,733.33) ( 6,833.33)
NET INTAKE 9,733.33 10,266.6 20,000
In this example , the loss after giving interest, salary and bonus shall likewise be distributed in accordance with their sharing ratio.
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ANOTHER TYPE OF PROFIT DISTRIBUTION IS THE GIVING MINIMUM GUARANTEED SHARE IN PROFITS TO PARTNER.
This system entitled a partner a minimum share of profits including interest , salaries, bonus . that means he is assured to received that minimum amount , whether the profit is not sufficient to pay the other partner, in which case the other partner has to reduced their share on the profits.
REMEMBER FOR YOU TO BE ABLE TO VIEW OR TO GRASP THE OVERALL PICTURE OF THE PROFIT DISTRIBUTION FOR EASY ANALYSIS , YOU HAVE TO DRAW THE FORMAT OF THE PROFIT DISTRIBUTION AS SHOWN BY THE SUCCEEDING ILLUSTRATION.
this is about a partner being given a MINIMUM GUARRANTEED SHARE ON THE PROFITS.
EXAMPLE.
A, B C, partners, with profit sharing ratio of 5: 2: 3: respectively . A to receive interest 1,000, B, 2,000 C, 2000.
A receives salary 3,000 . B to receive a minimum share of the profit of 10,000.00. the profit is 15,000.00
A B C TOTAL
INTEREST 1000 2,000 2000 5000
SALARY 3000 3000
______________________________________8000__________________8000___________
4,000 10000 2000 16000
PROFIT 15,000
REMAIN (SHORTAGE) (625) ( 375) (1000)
final shareSHARE 3375 10,000 1625 15,000
What maybe the issue here is how to compute for the share of A , C on the lacking of profit as a result of the minimum of 10000 of B.
Take note that the profit is only 15,000 and the initial fixed share of A , C is 6000 ( A 4000 , C 2000) plus the minimum share of B of 10,000 or a total of 16,000, which is short of 1,000 , which shall be divided between A, C. . B is not subject to share because he is assured of the 10,000 therefore A C HAS to absorb the shortage.
Now since A , C has a 50% share , C has a 30% on the profit sharing ratio. their total contribution as to sharing is 80%, so their effective share without B is as ff:
A 50% DIVIDE 80% IS 62.5%
c 30% DIVIDE 80% IS 37.5%
How do you compute for the equivalent percent when what is given is in terms of whole number and not in percentage. like 5: 3: 2 -= 10
simply add the total of all numbers then , now to get their individual percentage ratio is DIVIDE their number by the TOTAL OF THE ALL THE NUMBERS. 5/10 3/10 2/10
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Being the accountant of the partnership, you must pre compute the needed profit so that the minimum guarranted share of the partner and the interest and salaries ONLY of the other partner can be met.
IN THIS WAY , by mere seeing the actual profit you would know whether the partner can have a share on the remaining profits . In the above example , it is 16,000.00 .
You must also TO PRE COMPUTE , THE needed partnership profit where the other partner not receiving minimum share can still share on the remaining profits, that means by simply getting the difference between the 16,000 and this pre computed profit, the partners not receiving a minimum guarranteed share will likewise received his share on the remaining profit.
HOW DO YOU DETERMINE THAT PROFIT ON THAT CONDITION.
This profit pre determination presupposes that the one receiving the minimum has also have the share on the remaining profit, that means , HIS GUARRANTEED SHARE LESS HIS INTEREST , SALARIES is presumed his share on the profits, THIS SHARE is of course represented by his profit sharing ratio, THAT MEANS DIVIDING THIS SHARE ON THE PROFIT BY HIS SHARING RATIO IS EQUAL TO THE REMAINING PROFIT AFTER THE INTEREST , SALARIES OF ALL THE PARTNERS. THAT MEANS THIS REMAINING PROFIT PLUS INTEREST/ SALARIES IS EQUAL TO THE pre computed PROFIT , SO THAT THE ONE RECEIVING A MINIMUM, AND THOSE NOT ENTITLED TO THE MINIMUM CAN ALSO SHARE ON THE REMAINING.
THIS PRE COMPUTED PROFIT IS A CONDITION WHERE ALL OF THE PARTNERS HAVE A CORRESPONDING SHARE ON THE REMAINING PROFIT.
THAT MEANS the profit IN EXCESS OF THIS PRE COMPUTED PROFIT , SHALL BE SHARED BY ALL OF THE PARTNERS BASED ON THEIR PROFIT AND LOSS SHARING RATIO.
THIS IS THE ILLUSTRATION:
____
DISTRIBUTION OF PROFITS AS FF:
A B C TOT
INTEREST 1000 2000 2000 5000
SALARY 3000 3000
TO complete B min share 8000 8000
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TOTAL 4000 10000 2000 16000
SHARE on remaining PROFIT 20000 12000 32000
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PRE COMPUTED PROFIT 24000 10000 14000 48000
THAT means if the partnership attains 48,000 profit, automatically , the above is their distribution.
this profit of 48,000 is the minimum profit so that the 8000 of B is really a representative of his 20% share in the profit because if 8000 is 20% therefore it came from a 40,000
Since , as explained, the 8000 pesos is presumed to be the share of B in the remaining profit having minimum share on the remaining profit , therefore dividing 8000 by 20% equals 40,000, hence this is the amount where A share ratio of 50% is multiplied which is equal to 20,000, C share ratio of 30% will equal to 12,000.00 .
so if you total the interest , salary which is 8000 plus the 40,000 supposed remaining profit would equal to 48,000.00 as the PRE COMPUTED PROFIT.
A QUIZ MAY APPEAR THAT SAY 53,000 IS THE SUPPOSED PROFIT THAT SHOULD BE ATTAIN SO THAT ALL THE PARTNERS HAVE A SHARE ON REMAINING PROFITS ON THE BASIS OF THE MINIMUM SHARE OF THE PARTNER WITH GUARANTEED SHARE OF 8,000, ASSUMING 5,000 IS HIS CORRESPONDING SHARE ON THE PROFIT TO SUFFICE HIS MINIMUM AND HAS A 10% SHARING RATIO. HOW MUCH IS THE REMAINING PROFIT TO BE SHARED BY THE PARTNERS. ANS. 5,000 DIVIDE 10% .
Any profit below 48,000 pesos but not less than 16,000 , the remaining profit shall be shared by A , C at 5/8 = 62.5% for A, 3/8 = 37.5% for C.
NOW , ANY PROFIT IN EXCESS OF 48,000. that excess, shall be divided among the partners based on their sharing ratio, the partner with minimum share shall again receive on this excess.
EXAMPLE: THE PROFIT IS 58,000.00
A B C TOTAL
INTEREST 1000 2000 2000 5000
SALARY 3000 3000
MINIMUM B 8000 8000
BASIC share 20,000 12000 32000
0------------------------------------------------------------------------------------------
sub total 24,000 10,000 14,000 48,000
excess of 10000 (48,000- 58000) 5000 3000 2000 10000
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total sharing 29,000 13000 16000 58000
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A QUESTION MAY ARISE WHEN , IT IS BEING ASKED HOW MUCH PROFIT IS NEEDED SO THAT B CAN HAVE A MINIMUM SHARE OF 10,000
Let me show the picture:
A B C TOTAL
interest 1000 2000 2000 5000
salary 3000 3000
subtotal 8000
balnce for B 8000 8000
PROFIT NEEDED 10,000 16000
That means 16,000 is the needed profit so that B is assured of 10,000 minimum share. take note that A , C have no share on the remaining profit of 8,000 because that remaining profit is for A alone to satisfy his minimum share.
the difference between these two pre computed profit , 16,000 and 48,000 , which is 32,000 shall be shared by A, B, C based on their sharing ratio. TAKE NOTE 8000 OF B 10,000 IS CONSIDERED HIS SHARE ON THE REMAINING PROFITS FOR PURPOSES OF DETERMINING THE PRE COMPUTED PROFIT WHERE ALL CAN HAVE ITS OWN SHARE ON THE REMAINING PROFITS.
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______________________________________________________________________________
ANOTHER ISSUE IS SUPPOSING AT THE SAME TIME C WILL HAVE AN AGGREGATE AMOUNT TO BE RECEIVED SAY 20,000, HOW MUCH PROFIT THE PARTNERSHIP MUST REGISTER. THIS WILL CHANGE THE PRE COMPUTED PROFIT AS EXPLAINED ABOVE DUE TO THE INTRODUCTION OF THIS AGGREGATE SHARE , WHERE THE PRE COMPUTED IS 48,000.
with min with aggre
A B C TOTAL
INTEREST 1,000 2000 2,000 5000
SALARY 3,000 3000
GUARANTEED 8000 8000
SHARE ON THE REMAINDER 30000 18,000 48,000
DESIRED PROFIT 34,000 10000 20,000 64,000
64,000 IS NOW THE PRE COMPUTED IF C MUST RECEIVE 20,000 AGGREGATE and that A will have also a share..
Explanation:
Since C has already a 2000 interest , so he needs only 18,000 to reach an aggregate of 20,000, and B has already received his minimum share of 10,000 . Since the 18,000 of C is his share on the remaining profit and since A , C combined share ratio is 80%, ( 50% plus 30%) the 18,000 of C represents 37.5% ( 30% divide 80%) therefore dividing 18,000 by 37.5% equals 48000 where the share of A of 62.5% ( 50%DIVIDE 80%) will be multiplied ( 48,000 x 62.5% = 30,000
the problem in this scheme is IF THE NET PROFIT FALLS BELOW 64,000, would C to receive the aggregate of 20,000 . let us say the net profit is 60,000. Does C would still have the 20,000 and therefore A will shoulder the difference . No. , the profit deficiency is to be shared by A, and C. in accordance to the ratio of its share using the total of their share ratio. as explained above. C 37.5%, A 62.5%.
THE PARTNER THAT IS ENTITLED TO AN AGGREGATE AMOUNT WOULD NOT RECEIVED SUCH AMOUNT IF AND WHEN THE PROFIT FALLS BELOW 64,000. EXAMPLE SUPPOSE THE PROFIT IS 20,000
A B C
interest 1000 2,000 2000
salary 3000
minimum 8000
sub total 4000 10,000 2000 16,000
remainder profit 2500 1500 4000
total sharing 6500 10000 3500 20,000
C did not receive the aggregate of 20,000. though B receive the minimum guarranteed 10000.
HOW ABOUT WHEN THE PROFIT IS MORE THAN THE 64,000 PRE COMPUTED PROFIT, SAY 84,000. HOW IS THE PROFIT DISTRIBUTED.
A B C TOTAL
interest 1000 2000 2000 5,000
salary 3000 3000
minimum 8000 8000
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subtotal 4000 10000 2000 16000
basic share 20000 12000 32000
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sub total 24000 10000 14000 48000
share on residual 18000 7200 10800 36000
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TOTAL SHARE 42,000 17200 24800 84000
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In the event that the profit is more than the pre computed profit which is 64,000, and the actual is 84,000. the aggregate of C is disregard , instead , A, C will have an initial or basic share , 50%, and 30% respectively on the 40,000. THIS 40000 is arrived by dividing 8000 of B\ share by his profit share OF 20%., A share is 50% x 40,000= 20,000 , C 30% x 40000 =12000, After that , any residual profit which is 36,000 ( 48,000 minus 84000) shall be divided to themselves , A , 50% X 36000, = 18,000 B 20% X 36.000, =7200 C , 30% X 36,000 =10800
basic share( 8000 divide 20%=40000) A 40000 X 50% =20,000, C 30% X 40,000 = 12,000.
share on residual (48000 less 84,000= 36,000)
A 36,000 X 50% = 18,000, B .20% X 36000_ 7200, C 36000 X 30%=10800
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NEXT TOPIC IS ABOUT FINANCIAL STATEMENT OF PARTNERSHIP
1. the salary allowances and the interest on capital as part of the sharing of profits are generally recognized as PROFIT DISTRIBUTION and NOT RECORDED AS EXPENSES IN THE PROFIT AND LOSS.
2. if the event that a partner extend loan to the partnership, the interest on such loans is considered at INTEREST EXPENSE..
ON THE BALANCE SHEET.
1. a partner can extend a loan to the partnership and this is recorded as LOANS PAYABLE any interest to paid by the partnership for that loan shall be recorded as interest expense.
2. a partner can borrow money from the partnership and recorded as LOANS RECEIVABLE. any interest collected from him shall be recorded as interest income.
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THE JOURNALIZATION PROCESS:
the following transactions affecting capital accounts and drawing accounts are recorded as ff:
WHAT TRANSACTIONS ARE DEBITED TO THE CAPITAL ACCOUNTS
1. PERMANENT WITHDRAWAL OF INVESTMENT OR CAPITAL
2. CREDIT BALANCE OF DRAWING ACCOUNTS
WHAT ARE TRANSACTIONS CREDITED TO CAPITAL ACCOUNTS
1. THE ORIGINAL INVESTMENTS
2. SUBSEQUENT INVESTMENT
3. DEBIT BALANCE OF DRAWING ACCOUNTS.
4. IF INTEREST , SALARY ARE TREATED AS EXPENSE.
WHAT TRANSACTIONS ARE DEBITED TO DRAWING ACCOUNTS
1. CASH, MERCHANDISE ,OTHER ASSETS DELIVERED TO THE PARTNER FOR PERSONAL USE. THIS IS CREDITED TO THE CORRESPONDING ASSETS.
2. PAYMENTS MADE BY THE PARTNERSHIP TO PAY THE PERSONAL LIABILITIES OFTHE PARTNER. THIS IS CREDITED TO CASH
3. ANY RECEIVABLE OF THE PARTNERSHIP THAT WAS COLLECTED BUT RECEIVED BY THE PARTNER IN PRIVATE CAPACITY. CREDITED TO RECEIVABLE ACCOUNT
4. PARTNERS SHARE ON THE LOSS OF THE FIRM.
DRAWING ACCOUNTS ARE CREDITED AS FF:
1. SALARY, INTEREST, TO THE PARTNERS.
2. PAYMENT OF PARTNERS USING HIS OWN MONEY TO PAY THE LIABILITIES OF THE PARNERSHIP. DEBITED TO THE APPROPRIATE ANY LIABILITY ACCOUNT
3. A PERSONAL RECEIVABLE OF THE PARTNERS BUT THE MONEY WAS DEPOSITED BY THE PARTNERSHIP. DEBITED TO CASH.
4. PARTNERS SHARE ON THE PROFITS
On profit distribution.
1. Interest and salaries as part of the distribution scheme of profits can be treated as expenses instead of profit distribution. the entry is:
SALARIES XXX
INTEREST XXX
CAPITAL XXX
in this is treated as expense, it is credited to capital instead of drawing account.
if treated as distribution of profits, the debit to income exp summary should include the distribution of remaining profit after salary and interest.
INCOME EXP SUMMARY XXX
DRAWING.................................... XXX
2. salaries , interest are treated as expense, the distribution of the remaining profits after the distribution of salaries and interest is recorded as ff:
INCOME AND EXPENSE SUMMARY XXX
DRAWING ACCOUNTS.................................XXX
take note that it is now credited to the drawing accounts.
3. since drawing account is temporary accounts , this is closed to the capital accounts
drawing.....................xxxxx
capital............................xxxxx
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ADJUSTMENTS OF NET INCOME OF PRIOR YEARS.
There are errors in the recording or even underrecording or overrecording or misrecording or non recording of financial transaction more particularly affecting profit and loss accounts in the past years which were uncover during the current year. Since the net income or net loss during those years were not accurate , the capital accounts are likewise not accurate HENCE a correction has to be made.
the correction of net income of priors is only made when the nominal or the profit and loss statement is affected.
What are the example of these errors.
1. an inventory valuation is erronenous, in quantity and costing
2. some unrecognized revenues, unrecorded expenditure or any expenses incurred but not recorded.
3. unrecorded sales revenue, unrecorded purchases.
Of course there are errors that only affected ASSETS vs. LIABILITIES ACCOUNT , which did not affect the profit and loss accounts and finally did not affect the capital accounts, though this should also be adjusted but may not part of the correction of prior years
the correction of these errors shall be effected to the CAPITAL ACCOUNTS , since the profit of the partnership is not accumulated to the RETAINED EARNING ACCOUNT but to the capital accounts.
When an inventory was overvalued at the end of the year, that means the inventory account was overdebited and the cost of sales was over credited, in this case the net profit is overstated because the cost of sales becomes smaller than it should be.
Similarly when the inventory was understated, the cost of sales is overdebited thereby decreasing the net profit.
When a sales was made but no entry to record the receivable and sales account, the profit and loss decreases.
and there are many more cases of errors of prior years that affects the profit and loss, that need to be adjusted .
What is difficult here is how the inventory errors are to be corrected . there are two types of inventory recording , ONE IS THE PERPETUAL INVENTORY METHOD and THE PERIODIC INVENTORY METHOD.
The periodic inventory method is where an actual count is taken and the proper costing is done. This actual inventory count shall be the basis in the recording of the INVENTORY TO BE REFLECTED ON THE BALANCE SHEET , ANY ERRORS IN THE INVENTORY OF LAST YEAR SHALL BE AUTOMATICALLY ADJUSTED because the actual count and the actual cost shall be used to value the ending inventory.
let me cite an example.
Last year the inventory was counted and there are 4 units at 3.00 per unit or total cost of 12.00 . Unfortunately 22.00 was actually recorded as the inventory amount ., therefore last year, the inventory is overstated by 10.00 therefore the cost of sales is understated by 10.00 making the profit bigger than it should be.
This year let us say, there is transaction, just to simply the matter, but again an inventory was counted and the count is expectedly to be 4 units at 3.00 per unit. or a total value of 12.00 Of course , since we are using the PERPETUAL INVENTORY METHOD, the actual inventory value should appear on the balance sheet, since the present balance of the inventory in the balance sheet is 22.00 ( since no purchase no sales was made ) this 22.00 should be adjusted to make it 12.00 because 12.00 is the actual inventory. So that this year , the cost of sales is overstated by 10.00, because when you CLOSE the existing 22.00 pesos BEGININNING INVENTORY , you credit inventory account 22.00 and debit cost of sales 22.00 and then you debit inventory account 12.00 and credit cost of sales 12.00 to set up the INVENTORY END. So the last year UNDERSTATEMENT OF COST OF SALES ( which is erroneous) is now offset by the OVERSTATEMENT this year.
that is why if it was said that the last year inventory is overstated or understand , there is no need to adjust the inventory of last year and the capital of the partners, because, the inventory was automatically adjusted anyway because of the perpetual system.
THE perpetual inventory method is where the THEORETICAL INVENTORY ACCOUNT remains to be the INVENTORY REFLECTED ON THE BALANCE SHEET, no actual inventory is taken and therefore the book balance remains to be the INVENTORY ON THE BALANCE SHEET.
However, when the periodic inventory method is being used, where the actual inventory is not being used to adjust the theoretical balance, any shortage, overage, wrong costing in the actual inventory cost remains uncorrected, therefore year by year the book balance of the INVENTORY ACCOUNT remains uncorrected, therefore , when periodic inventory method is used , and suddenly when an actual count is conducted on the inventory at the end of the year after the books are closed, then a correcting entry has to be made TO ADJUST THE CAPITAL OF EACH PARTNER AND TO CORRECT THE INVENTORY ACCOUNT . AS A RESULT OF THE ERROR IN INVENTORY VALUE THE PROFIT ALSO IS ERRONEOUS BECAUSE OF THE WRONG INVENTORY VALUE.
ANY OTHER ERROR IN THE PREVIOUS YEARS , SAY OVER/ UNDER RECORDING OF EXPENSES AND OR REVENUES, SAY , ACCRUAL OF EXPENSES, PREPAID EXPENSES, UNRECORDED SALES , SHOULD NOT BE AUTOMATICALLY ADJUSTED. It must be first check whether those errors in previous years were not corrected the following year , if it is already adjusted the following year , there is no need to adjust.
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THE ARRANGEMENT OF PARTNERS TO BRING THEIR CAPITAL TO CONFORM WITH THEIR PROFIT AND LOSS SHARING RATIO
The profit and loss sharing ratio is not automatically mean that this ratio is the ratio of their capital to the total capital of the firm because that is not the only basis in determining their sharing ratio.
There are three system that would bring their capital balance to their sharing ratio
1. if after the establishment of the supposed capital to conform with sharing ratio, partners should pay from their own money the partner whose revised capital increases. an entry has to be made to effect this changes in capital.
2. whoever has the original capital THAT when divided by his ratio will produce the highest supposed capital SHALL MAINTAIN HIS ORIGINAL CAPITAL. the firm shall pay the partners.
.
3. any partner whose original capital when divided by his share result to the lowest supposed TOTAL CAPITAL OF THE FIRM will have to maintain his original capital. the rest of the partners will have a lower desired capital. THE FIRM shall pay the partner whose capital did not changed and charged or debited to the capital account of the other partners.
EXAMPLE:
A, B , C has a sharing ratio of 45%, 30%, 25%, their capital are 30,000 , 25,000, 5000 a total of 60,000.00.
ISSUE:
1. what would be the SUPPOSED TOTAL OF CAPITAL of each partner to attain the profit sharing ratio
2. how much would be the SUPPOSED TOTAL CAPITAL if any partner capital when divided by his ratio will produced the highest SUPPOSED CAPITAL OF THE FIRM.
3. how much would be the DESIRED CAPITAL if any partners capital divided by his ratio will produce the lowest total capital of the firm.
solution for no. 1.
Since their present capital does not conform with their present ratio, SAY, A share ratio si 45% but his capital divide 60 is 50%. all you have to do is multiply their ratio to the present total capitalization to arrive at their supposed capital.
A 45% X 60,000 = 27,000 45% supposed capital (to pay C 3,000
B 30% X 60,000 = 18,000 30% supposed capital (to pay C 7,000
C 25% X 60,000 = 15,000 25% to receive money or equivalent from A , B, total 10,000.
journal entry:
CAPITAL A 3,000
B 7000
CAPITAL C 10,000
SOLUTION NO. for 2.
Since, B when dividing his capital to his ratio of 30% result to the highest supposed total capital of 83,333.33 his capital should remain the same
A B C TOTAL
CAPITAL 30,000 25,000 5000 60000
desired capital 37,500 25,000 20,833.33 83,333.33
cash investment 7500 15,833.33 23,333.33
A and C now should put up additional investment to bring their capital to 45%, 25% respectivelly
cash 23,333.33
A CAP 7500
C CAP 15,333.33
SOLUTION NO.for 3.
this is the reverse of no. 2. what is being determined here is whose capital when divided by its ratio will produce the lowest DESIRED CAPITAL, since , C dividing 5000 by 25% result to 20,000 which is the lowest supposed capital., his original capital should remain the same.
AS A REVIEW LET ME GIVE SOME TEST.
PARTNERSHIP FORMATION:
CASE NO. 1
X, AND A form a partnership and agree to share profit and loss in the ratio of 64.7%, 35.3% respectively. they have both owners of their own business and they have had the following balance sheets.
PER BOOKS MARKET VALUE.
A B A B
CASH 30,000 20,000 30,000 20,000
INVENTORY 20,000 30,000 30,000 35,000
PAYABLE 5,000 25,000 5,000 25,000
the capital is not given.
make the opening entry int he new partnership under the following assumptions.
1. partners agreed to use net investment method.
2. partners agree to share capital equally but not bonus and goodwill.
3. partners agreed that the capital of B should be 50,000 AND no goodwill is to be recorded
4. agreed to recognize goodwil of 5,000 to be credited to capital of the partners in amount that will maintain their balances equal to ther profit and loss ratio.
Reminder.
1 net investment method is whatever they brought to the firm is their investment/
2. when capital must be equal , and no bonus nor goodwill given then , an additional investment is needed.
3. when they want to bring their capital equal OR EVEN UNEQUAL but no investment to be made by other partner then a bonus is expected.
4. when no bonus but the capital of the partner will equal or went up then a goodwill is recognized OR WHEN A GOODWILL WILL BE RECOGNIZED FOR BOTH PARTNERS , THAT MEANS THE TOTAL CAPITALIZATION WILL INCREASE BY THE TOTAL GOODWILL.
ANOTHER TEST CASE.
A, B partners with the following capital movement during the year.
debit credit
A Jan 1 30,000
april 1 2,000
july 4000
B JAN 15000
marc 1 3000
sept 1 1,000
they agreed to divide profit according to capital balances.
a. interest of 16% is allowed on average capital
b. salaries are allowed to B 8,000 and a 5,000
C. bonus of 15% given to A.
REQUIRED:
1. compute the average capital
2. compute the interest
3. net income is 55,000 and that bonus is treated as expense , make a distribution sched.
5. net income is 30,000 and bonus treated as distribution of profit, make sched.
I repeat, when bonus is treated as expense the , the bonus is computed based on net income before bonus. If bonus is treated as distribtution of profit then bonus computed based on net income after bonus.
Remember in computing the base amount of the bonus rate of 15% which is the net income after bonus . you have to to determine the equivalent percentage of the 30,000 by worked back approach, remember the 30,000 is not the 100% because it is not the base amount to multiply the 15% bonus.
again in making the entry on bonus treated as expense , it is credited to CAPITAL account.
ANOTHER TEST CASE.
A, B, C , D firm formed last July 1, their capital were:
A. 100,000 , B, 50,000,, C 50,000 D, 40,000
Each partner to receive 5% interest based their capital contribution. A to receive salary of 10,000 and B 6,000 chargeable to expense.
C to receive minimum of 5,000 , D to receive minimum of 12,000 . the remaining balance after this interest, salaries minimum shall be shared 30.%, 30%, 20%, 20% respectively..
Required .
1. calculate the amount of profit , in order that A, may received an aggregate of 25,000 , that 25,000 , the interest , the salaries , share of profit is already there.
2, suppose the profit is 35,000 , what would the distribution of profit.
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CHANGES IN OWNERSHIP OF THE FIRM
IF AN ADDITIONAL OR NEW PARTNER IS ADDED, OR AN EXISTING PARTNER WITHDRAW OR DIES AND THE REMAINING PARTNERS CONTINUE , A NEW PARTNERSHIP
WILL BE CREATED , IN SUCH A CASE a dissolution will OCCUR.
A partnership is dissolved in the following scenario
1. admission of a new partner
2. withdrawal and death of existing partner
3. selling of the partnership
4. conversion into a corporation.
5. liquidation of the business.
in case of admission of new partner and a withdrawal , death, a new articles of a partnership is prepared.
ADMISSION OF A NEW PARTNER.
The new partner may purchase a portion or the whole interest of an old partner and this called PURCHASE OF AN EXISTING INTEREST.
THREE TYPES OF PURCHASE MODE.
1. purchase AT book value. the purchase price is equal to the book value of equity, that means the amount to be paid by the incoming partner is exactly equivalent to the share he wants to acquire..
a. purchase of interest from one partner. - the payment is made directly to the selling partner .
2. purchase above book value = the payment to be made by the buying partner is more than the value of the equity to be sold. it may be on the following manner.
a. bonus method = the difference between the cash payment and the value of the equity is considered bonus to the existing partners.
b. revaluation of assets method = that means the existing assets will be overvalued in such a way that an assets will increase and therefore the capital accounts of the existing partners will increase in accordance with their sharing ratio. the amount of increase of the assets is computed based on the following principle. WHEN A NEW PARTNER INDICATES THAT HE WANTS TO PURCHASE THE EQUITY OF THE EXISTING PARTNERS BY INDICATING HIS DESIRED RATIO ON THE TOTAL NEW CAPITAL , THE TENDENCY IS IF YOU DIVIDE THE AMOUNT HE WANTS TO PAY BYHIS DESIRED SHARE RATIO, THE RESULTING ANSWER IS THE NEW ASSETS TOTAL WHICH IS BIGGER THAN THE ORIGINAL , THAT DIFFERENCE SHALL BE CREDITED TO THE CAPITAL OF THE EXISTING PARTNERS AND DEBITED TO THE AFFECTED ASSETS.
C. goodwill method = that means the existing partner argues that they have develop a goodwill on their business and therefore a goodwill value will be credited first to their account.
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3. PURCHASE BELOW BOOK VALUE =
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a. PURCHASE BELOW BOOK VALUE BY WAY OF BONUS, IN THIS SYSTEM IT IS THE PURCHASE WHO WILL RECEIVE THE BONUS.
b. purchase below book value by way of revaluation of assets.- that means the value of the existing assets of the partnership shall be downgraded, and that equivalent reduction of assets is credited to the incoming partner.
IN PURCHASE BELOW BOOK VALUE , THERE IS NO GOODWILL ACCORDED TO THE NEW PARTNER.
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EXAMPLE :
A. PURCHASE OF BOOK VALUE.
A, B, are partners ,sharing 60%, 40%, the following are their balance sheet.
ASSETS 500,000 CAPITAL A 300,000
B 200,000
Mr. X , wants to purchase 20% of the share of the A, B at 100,00.
the entry is :
CAPITAL A 60,000
B 40,000
CAPITAL X 100,000
the 60,000 is arrived by 60% share of A x 100,000= 60000, 40% x 100,000= 40,000
Why debited to capital of A, B , because they sell their part of their capital.
B PURCHASE ABOVE BOOK VALUE BY WAY OF BONUS.
Mr. X agrees to purchase 30% at 175,000 . Since 30% of 500,000 is 150,000 only but X is willing to pay 175,000, that means A , B will divide the 25,000 among themselves privately . that means the 25,000 will not go the firm.
.
entry is
A CAPITAL 90000
B CAPITAL 60000
X CAP 150000
C.. PURCHASE ABOVE BOOK VALUE BUT BY WAY OF REVALUATION OF ASSETS.
IN THIS REVALUATION OF ASSETS, YOU SHOULD ASSUME THAT AUTOMATICALLY THE NEW PARTNERS CAPITAL WILL BE THAT AGREED SHARE AMOUNT DIVIDE THE AGREED SHARE RATIO FOR HIS CAPITAL, then you get the new capital . IN THIS ASSUMPTION THE TENDENCY IS TO HAVE A BIGGER TOTAL NEW CAPITAL OR A BIGGER TOTAL ASSETS , THAT INCREASE OF THE TOTAL ASSETS SHALL BE CREDITED TO THE EXISTING PARTNER. AFTERWHICH THE CAPITAL OF THE EXISTING PARTNER WILL BE REDUCED AS A RESULT OF THE PURCHASE OF THE NEW PARTNER.
Mr X agrees to by 20% of the share of the partnership at 200,000. . That means , his share must be equivalent to 20% of the total capital, therefore the supposed capital of the new partnership must be 1,000,000, 200,000 divide 20% =1000000
Now since the agreement is a REVALUATION OF ASSETS, THE PRESENT ASSETS OF
500.000 must be made to become 1000000, therefore an assets shall be debited to increase the total assets by 500,000 to make it 1,000,000. If assuming the LAND was the one revalued then it is debited to LAND ACCOUNT.
LAND 500,000
A CAPITAL 300,000 500000 x 60%
B CAP 200,000 500,000 x 40%
to credit the account of A, B AS a result of increase in assets.
A CAPITAL 120,000 200,000 x 60%
B CAP 80,000 200000 x 40%
X CAP 200,000
to record the investment of X , and reducing the A, B capital due to the sales of their equity .
the capital transactions would appear as ff
A B X total
original 300000 200000 500000
assets revaluation 300000 200000 500000
Selling 120,000 80,000 200,000 -
total 480000 320000 200000 1000000
D.. purchase above book value but by BY WAY OF GOODWILL.
THIS IS basically the same with REVALUATION except that the assets will not be revalued but the existing partner would argue that their business has accumulated some goodwill, therefore their capitalization must increase out of this goodwill. So the GOODWILL ACOUNT will be debited and credited to the CAPITAL ACCOUNTS OF EXISTING PARTNER.
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3. PURCHASE BELOW BOOK VALUE BY WAY OF BONUS.= in this agreement , the INCOMING PARTNER will be credited with a bigger amount compared with the amount he will pay the existing partner.
Example:
MR. X wants to purchase 30% of partners capital but by paying 130,000. 30% of 500,000 is 150,000 as his capital credit but he will only pay the partners 130000 , that means he will receive a bonus of 20,000.00
A CAPITAL 90,000 150,000 x 60%
B 60,000 150,000 x 40%
X 150,000
to record purchase of A , B CAPITAL By mr. X at 150,000 but paying only 120,000
PURCHASE BELOW BOOK VALUE BY WAY OF REVALUATION OF ASSETS. iN THIS METHOD, THE ASSETS OF THE FIRM WILL BECOME SMALLER
EXAMPLE.
mR x TO PURCHASE EQUITY OF A, B at 135,000 to represent a share of 30%., that means dividing 135,000 by 30%, = 450,000 which will be the value of the existing assets of 500,000.00 or a decrease of 50,000, this 50,000 shall be debited to the account of the existing partner and credited to the appropriate asset account.
entry:
A CAP 30,000
B CA P 20,000
ASSET ACCOUNT 50,000
TO reduce the capital of A, B , to reflect the revaluation of assets and the reduction of assets due to revaluation..
A CAP 81000
B CAP 54000
X CAPITAL 135000
to reflect the purchase of A, B EQUITY BY X
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ADMISSION OF NEW PARTNER BY WAY OF INVESTMENTS OF A NEW PARTNER.
SIMILARLY IT HAS THE SAME METHOD OF VALUING THE INVESTMENT OF THE INCOMING PARTNER.
1. INVESTMENT AT BOOK VALUE - this is where the amount of investment when added to the existing capital of the old partner equals an AMOUNT, when multiplied to the agreed share ratio of the new partner will equal to his investment . or when the agreed capital multiply by the share ratio of the new partner equals the amount invested by the new partner.no more no less.
example:
EXISTING CAPITAL 600.000
NEW PARTNER INVESTMENT 200,000
TOTAL AGREED 800,000 X 25% SHARE of new = 200,000, his actual cash invested.
2. INVESTMENT ABOVE BOOK VALUE., there are 2 approaches
a. BONUS METHOD - this is situation where the amount you put in the partnership is more than what you will be credited to your capital account. , that means , that excess shall be credited to the old partner as A BONUS that the new partner will give to the old partner. Of course this is a precomputed thing, they agreed that capital of the old partner will increase by a certain amount represented by a bonus, that amount now will be added to the agreed share of the new partner and that amount will be the cash outlay of the new partner.
If the equivalent share ratio of the new partner multiplied by the FINAL CAPITAL , is said to be your capital credit,, IF THE AMOUNT OF YOUR ACTUAL MONEY INVESTED IS MORE THEN THERE IS A BONUS TO THE OLD PARTNER.
EXAMPLE:
AMOUNT OF INVESTMENT NEW PARTNER 300,000
the agreement is new partner will be credited only b 225,000 25% OF 900,000
BONUS YOU GIVE TO THE OLD PARTNERS 75,000 to be credited to their account
EXISTING CAPITAL 600,000
BONUS TO BE ADDED TO CAPITAL OF OLD 75000
NEW PARTNER CREDITED 225,000
AGREED CAPITAL 900,000
the agreement will specify the would be share ratio of the new partner against the would be CAPITAL OR THE AGREED CAPITAL, IN THIS CASE, 25% IS share ratio of new partner to the 900,000 which is exactly 225,000. But since the incoming partner cash outlay is 300,000 that means the excess of 75,000 shall be credited to the old partner based on their existing sharing ratio, courtesy of new partner.
b. GOODWILL METHOD - this time the investment amount of new partner and the amount to be credited to him is the same unlike in bonus method.. the agreed total capital minus the capital credit of the new partner would equal to the new capital of the old partner, where this new capital is more than their original capital , because the old partner argued that they have established or develop a business GOODWILL THEY IMPUTED ON THEIR BUSINESS, that goodwill be credited to the old partner capital, based on sharing ratio. THAT MEANS IN GOODWILL, THE EXACT AMOUNT OF INVESTMENT OF NEW PARTNER IS SURELY CREDITED TO HIS ACCOUNT, UNLIKE IN BONUS THE AMOUNT GIVEN IS NOT THE AMOUNT CREDITED.
EXAMPLE:
the new partner will contribute 130,000 and this amount is EXACTLY 162/3 % of the agreed capital 780,000 ( 130,000 divide 16.2/3% =780,000) deducting 130,000 from 780,000 is 650,000 which is the total adjusted capital of the old partner but since their original capital is 600,000 , therefore a GOODWILL OF 50,000 WILL BE CREDITED TO THEIR ACCOUNT BASED ON THEIR SHARING RATIO.
if the problem says 16 2/3% share of new partner and the agreed capital is 780,000, to get the amount to be contributed by new partner , simply multiply 16 2/3 by 780,000.00 .
PRESENTATION:
A B NEW TOTAL
CAPITAL OLD PARTNER 420,000 180,000 600000
NEW PARTNER 130000 130000
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CONTRIBUTED CAP 420000 180,000 130000 730,000
FINAL CAPITAL AGREED CAP 780,000
GOODWILL 35000 15000 50,000
3. INVESTMENT BELOW BOOK VALUE.
BONUS METHOD.= it is just reverse of the bonus under investment above book value.
GOODWILL-
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There is a situation wherein BOTH BONUS AND GOODWILL ARE GIVEN TO THE OLD PARTNERS..
How is this explained.
Example:
a new partner will contribute say 150,000, BUT it says his new share ratio is 16 2/3% of the the AGREED CAPITAL of 840,000. .
SINCE THIS 16 2/3% OF THE AGREED CAPITAL IS ONLY 140,000, BUT HE PAYS 150,000 THAT MEANS THE NEW PARTNER WILL ONLY BE CREDITED UP TO 140,000 BUT THE NEW PARTNER WILL INVEST 150,000 therefore there is an EXCESS OF 10,000 WHICH will be credited to the account of the existing partner.
Now after the 140,000 and the 10,000 was credited to their individual capital, the total capital is only 750,000, but the agreed capital should be 840,000, therefore , the old partner will received a GOODWILL OF 90,000.
PRESENTATION:
A B C TOTAL
OLD PARTNER EXISTING CAP 420,000 180,000 600000
NEW PARTNER ACTUAL CASH 150,000 150000
BONUS 7000 3000 ( 10000) 0
SUB TOTAL 427000 183000 140,.000 750,000
SUPPOSED CAPITAL 490,000 210000 140000 840,000 100%
GOODWILL 63000 27000 90,000
ANOTHER EXAMPLE:
THIS TIME BONUS TO NEW PARTNER. THIS IS REVERSE OF THE BONUS TO OLD PARTNER.
NEW PARTNER TO INVEST 120,000 BUT WITH 20% SHARE ON THE NEW CAPITAL OF 720,000.
Here 20% of of the final capital is 144,000, but the new partner invest only 120,000, therefore a bonus is given to the new partner because he contributes only 120,000 but his capital account was credited of 144,000 , the 24,000 will be debited to the capital account of the old partner.
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GOODWILL TO THE NEW PARTNER
EXAMPLE:
NEW PARTNER TO INVEST 300,000 BUT 40% SHARE ON THE FINAL CAPITAL OF 1,000,000.
The new partner should have invested 400,000 , 40% of 1,000,000 but he invested only 300,000 , therefore he was given bonus by the old partner, so the 100,000 shall be debited to the account of the old partner.
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GOODWILL AND BONUS TO THE NEW PARTNER
Example. new partner invest 160,000 but his share ratios 25% of final capital of 780,000.00 . If you multiply 25% of 780,000 , the new partner will be credited 195,000.
Since goodwill is computed as ff:\\
AGREED CAPITAL 780,000
CONTRIBUTED CAP 760,000
GOODWILL 20,000
The bonus is computed as Ff:
Actual cash invested by new partner 160,000
plus the goodwill credited to him 20,000
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total initial credit to his account 180,000
AMOUNT TO FINALLY FOR HIS CREDIT 195,000
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LACKING SO BONUS IS GIVEN 15,000
THIS IS QUITE DIFFERENT COMPARED TO BONUS GIVEN TO OLD PARTNER. IN THE BONUS GIVEN TO OLD PARTNER THIS IS THE COMPUTATION
amount to be credited to new partner ................... 140,000.
less: actual cash invested...................................... 150.000
bonus 10000
BUT IN GIVING BONUS TO NEW , BESIDES THE ACTUAL CASH INVESTMENT , THE GOODWILL IS ADDED TO ARRIVE AT THE TOTAL CREDIT GIVEN TO THE NEW PARTNER AS SHOWN ABOVE.
PRESENTATION
NEW TOTAL
EXISTING CAPITAL 420,000 180,000 600000
NEW PARTNER 160000 160000
TOTAL CONTRIBUTED CAP 760,000
bonus ( 10500 4500 ) 15000 -0
agreed captial 780,000
goodwill 20,000 20,000
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THERE ARE TIMES WHEN, THE BONUS OR THE GOODWILL is given to new partner but IS NOT EXPRESS BUT ARE IMPLIED.
EXAMPLE. A, B C partner with 10,000, 20,000 40,000 capital or total of 70,000.00. D is accepted to the partnership giving 14,000.00 for a 20% share on the capital. the intended capital was not mentioned. .
AS BONUS"
When a bonus is being given to the new partner , the amount contributed is lesser than what is to be credited to him as capital. in this case what should be done in such a way that his capital credit is more than his amount of contribution. the best way is to consider the contributed capital as the agreed capital where the percent share is to be multiplied to arrive at the amount to be credited to the new partner. Like this:
20% x 84,000 = 16800.00 as the capital credited
amount invested 14,000.00\
bonus 2,800.00
entry:
DEBIT , A B, C CAPITAL 2800
D CAP 2800
AS GOODWILL
When a goodwill is given to a new partner . similarly his actual contribution is lesser than the amount to be credited to him, but the CAPITAL OF THE OLD PARTNER WILL NOT CHANGED OR REDUCED, UNLIKE IN bonus.
If this is the case , that the old partners capital will not change , therefore , their capital will the basis in computing the final capital and since new partner share is 20% , the old partner has 80%, therefore:
70,000 divide 80%= 87,500.00 as the final capital
less: old capital 70,000.00 ORIGINAL CAPITAL
credited to D 17,500.00 TO BE CREDITED TO D
LESS: contributed 14,000.00 CASH CONTRIBUTED BY D
GOODWILL 3,500.00 GOODWILL GIVEN TO HIM
JOURNAL entry
goodwill 3,500.00
D CAPITAL 3,500.00
