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Advacc book

Intermediate Accounting 1 (AMA Computer University)

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CHAPTER 1 : FORMATION AND OPERATION

The adjustment of books of new partnership is through
PLURARITY OF CAPITAL ACCOUNT AND DRAWING ACCOUNTS: capital accounts. The capital account is credited for the
increases in the value of net assets and is debited for decreases
CAPITAL ACCOUNT in the value of the net assets (asset and liabilities). To close the
balance accounts of the partner that are not to be used by the
partnership, all accounts with debited balances are credited and
1. Permanent withdrawal 1. Original investment by vice versa.
(decrease) of capital a partner
2. Share in partnership 2. Share in partnership The excess of the capital credited to any sole proprietorship
loss from operations profits from operations over the agreed value or fair market value of the net assets
3. Debit balance of 3. Additional investment acquired by the partnership is treated as goodwill. The
drawing account closed by a partner adjustment of goodwill increases the capital of the sole
to capital proprietor

CAPITAL SHARE AND CAPITAL CONTRIBUTION

DRAWING ACCOUNT
The capital share of each partner is the percentage of equity
that each of them will gave in the net asset of the newly formed
1. Personal withdrawal by 1. Share in partnership
partnership.
a partner in anticipation profits from operations
 Proportionate to his/her capital contribution
of profits (Temporary (this may be credited
 Not proportionate to their capital contribute (or
withdrawal of Capital) directly to capital)
contribute expertise) Allowing Bonus on initial
2. Share in partnership investment.
loss from operations  Net assets = total assets – total liabilities
(this may be debited
directly to capital)
LOAN RECEIVABLE AND LOAN PAYABLE

A loan from a partner is shown as loan payable (partner to

PARTNERSHIP FORMATION partnership) on the partnership books, similar to any other loan.
Unless all partners agree otherwise; the partnership is obligated
 Contribute cash, property and industry to pay to the individual partner interest (expense in income
 Asset : Debited (asset account), Credited (capital account) statement) on the loan. Loan receivable from the partner
 Liabilities : present value (partnership to partner), again unless otherwise agreed by the
 Cash – Face value partners, the loan bears interest (income in income statement).
 Non-Cash – Agrees values, Fair market value
 Service – memorandum entry PARNERSHIP OPERATIONS AND DISTRIBUTION OF
PROFITS AND LOSSES
The capital account of each partner reflects all of the activity
of an individual partner, contribution, withdrawals, and the Accounting for partnership operations is essentially the same
distributive share of net income (loss). In some cases, a drawing as accounting for the operations of any other form of business
account is used as a clearing account for each partner’s organization.
transactions with only the net effect of each period’s activity CLOSING ENTRIES OF PARTNERSHIP
shown I the capital account.

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1. All revenue and nominal account with credit balance are ORDER OF PROFIT SHAING PROVISION: bonus, salaries, interest, and
debited and income summary is credited. remainder. The bonus is computed on the basis of partnership
2. Income summary is debited and all expense and other profit as the concept of “partnership net profit” is generally
nominal accounts with debit balances are credited. understood in accounting practice. Partners may, however
3. The balance of the income summary account (profit or loss) intend for salary and interest allowances to be deducted in
is transferred to either the drawing accounts or capital determining the base for computing the bonus. In such case, no
accounts. bonus is allowed if there is insufficient profit after distribution of
4. The balance of the drawing of each partner is transferred to salaries and interest.
his/her capital account.
ORDER OF PRIORITY PROVISION: the partners may agree not to use a
The balance of the income summary account is transferred to residual sharing ratio in the event profits did not exceed the
the drawing accounts of the partners if the partner intention is total of the salary and interest allowances. In this case, the
to keep the capital account intact for investment or permanent partners must agree on the priority of the various features. If
withdrawals of capital. A credit balance in income summary the partnership agreement gives salary allowances priority over
account represents a profit and its balance is transferred to the interest on capital balances, then profit would first apply to
drawing accounts of the partners based on their P & L sharing salaries and the balance would be divided in to the ratio of
ratio. interest allowances and vice versa.

DISTRIBUTION OF PROFITS AND LOSSES SPECIAL PROFIT ALLOCATION METHODS

1. Services rendered by the partners to the partnership – Most public accounting firms distribute profits on the basis of
salaries partnership “units”. A new partner acquires a certain number of
2. Amount of capital contributed by the partners – interest units and additional units are assigned by firm wide
3. Entrepreneurial ability or managerial skills – bonus compensation committee based on:
 Obtaining new client, providing the firm with specific areas of
P & L division: Percentage, Fraction, Decimal, Ratio industrial expertise, serving as a managing partner of a local
office, or accepting a variety of other responsibilities.
METHODS OF DISTRIBUTING PROFITS BASED ON PARTNERSHIP AGREEMENT
1. Equally Many partnerships use profit and loss sharing formula that gives
2. Arbitrary ratio (percentage, decimal, fraction, ratio) some weight to specific performance of each partner. Some of
3. Capital ratio (original, beg, end, average) note: in computing these performance methods are the ff: chargeable hours, total
average cap ratio, if the problem is in sentence or t-account (x the given month billings, promotional and civic activities.
up to December), if the problem is in capital account (x the given month up to
the next given month). Be careful with date! 1 not include, 30/31 include in
counting. Other partnerships devise profit distribution plans that reflect
4. Interest the earnings of the partnership. Other criteria may include
5. Salaries number or size of clients, years of service within the firm, or the
6. Bonus to managing partner - (if there is profit) partner’s position within the firm.
a. Before deducting bonus and tax (B = BR x I)
b. After deducting bonus but before deducting tax CORRECTION IN NET PROFIT FOR ERRORS AND
(B = BR x I – B) OMISSIONS PRIOR TO DISTRIBUTION
c. Before deducting bonus but after deducting tax
(B = BR x I – T) The errors may also affect the computation or a prior
d. After deducting bonus and after deducting tax period’s profit. The central issue, however, is whether the
(B = BR x I – B – T/S) correction would affect the profit of the current year (the year in

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which the error is discovered) or the profit of the prior year (the
year in which the error occurred). When the error is corrected as
adjustment to prior year’s profit, the allocation of profit for
the prior year should be recalculated based on the corrected
profit and the profit-and-loss sharing agreement in effect during
the prior period. When the error is corrected as adjustment to
current year’s profit only, the adjustment is allocated among
capital accounts based on the corrected current year’s profit
and the profit and loss sharing agreement.

The required corrections to profit are summarized as follows:

Correction to profit of current
year for errors made in:
Prior year Current year
1. Unrecorded prepaid expenses - +
2. Unrecorded accrued expenses +
-
3. Unrecorded accrued income - +
4. Unrecorded unearned income + -
5. Overstatement of inventories + -
6. Understatement of inventories -
+
7. Overstatement of purchases - +
8. Understatement of purchases + -
9. Overstatement of depreciation none
+
10. Understatement of depreciation none -

CAPITAL RATIO ADJUSTED TO PROFIT AND LOSS RATIO

While it is usual that capital ratios do not equal profit and loss
ratios, partners may decide to bring their capita balances into
their profit and loss ratio.
1. By payments outside of the firm among the partners and
where the total firm capital is to remain the same.
2. By lowest possible additional cash investment in the firm.
Higher than capital contribution
3. By lowest possible additional investment or cash
withdrawal from the firm by the partners. Lower than
capital contribution

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