Dividing Income or Loss
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Partners are not employees of the partnership but are its owners. If partners devote their time and services to their partnership, they are understood to do so for profit, not for salary. This means there are no salaries to partners that are reported as expenses on the partnership income statement. However, when net income or loss of a partnership is allocated among partners, the partners can agree to allocate “salary allowances” reflecting the relative value of services provided. Partners also can agree to allocate “interest allowances” based on the amount invested. For instance, since Zayn contributes three times the investment of Perez, it is only fair that this be considered when allocating income between them. Like salary allowances, these interest allowances are not expenses on the income statement.
Point: Partners can agree on a ratio to divide income and another ratio to divide a loss.
Partners can agree to any method of dividing income or loss. In the absence of an agreement, the law says that the partners share income or loss of a partnership equally. If partners agree on how to share income but say nothing about losses, they share losses the same way they share income. Three common methods to divide income or loss use (1) a stated ratio basis, (2) the ratio of capital balances, or (3) salary and interest allowances and any remainder according to a fixed ratio. We explain each of these methods in this section.
Allocation on Stated Ratios
The stated ratio (also called the income-and-loss-sharing ratio, the profit and loss ratio, or the P&L ratio) method of allocating partnership income or loss gives each partner a fraction of the total. Partners must agree on the fractional share each receives. To illustrate, assume the partnership agreement of K. Zayn and H. Perez says Zayn receives two-thirds and Perez one-third of partnership income and loss. If their partnership’s net income is $60,000, it is allocated to the partners when the Income Summary account is closed as follows.
Point: The fractional basis can be stated as a proportion, ratio, or percent. For example, a 3:2 basis is the same as ⅗ and ⅔, or 60% and 40%.
Allocation on Capital Balances
The capital balances method of allocating partnership income or loss assigns an amount based on the ratio of each partner’s relative capital balance. If Zayn and Perez agree to share income and loss on the ratio of their beginning capital balances—Zayn’s $30,000 and Perez’s $10,000—Zayn receives three-fourths of any income or loss ($30,000/$40,000) and Perez receives one-fourth ($10,000/$40,000). The journal entry follows the same format as that using stated ratios (see the preceding entries).
Point: To determine the percent of income received by each partner, divide an individual partner’s share by total net income.
Allocation on Services, Capital, and Stated Ratios
The services, capital, and stated ratio method of allocating partnership income or loss recognizes that service and capital contributions of partners often are not equal. Salary allowances can make up for differences in service contributions. Interest allowances can make up for unequal capital contributions. Also, the allocation of income and loss can include both salary and interest allowances. To illustrate, assume that the partnership agreement of K. Zayn and H. Perez reflects differences in service and capital contributions as follows: (1) annual salary allowances of $36,000 to Zayn and $24,000 to Perez, (2) annual interest allowances of 10% of a partner’s beginning-year capital balance, and (3) equal share of any remaining balance of income or loss. These salaries and interest allowances are not reported as expenses on the income statement. They are simply a means of dividing partnership income or loss. The remainder of this section provides two illustrations using this three-point allocation agreement.
Illustration when income exceeds allowance. If BOARDS has first-year net income of $70,000, and Zayn and Perez apply the three-point partnership agreement described in the prior paragraph, income is allocated as shown in Exhibit 12.1. Zayn gets $42,000 and Perez gets $28,000 of the $70,000 total.
Illustration when allowances exceed income. The sharing agreement between Zayn and Perez must be followed even if net income is less than the total of the allowances. For example, if BOARDS’ first-year net income is $50,000 instead of $70,000, it is allocated to the partners as shown in Exhibit 12.2. Computations for salaries and interest are identical to those in Exhibit 12.1. However, when we apply the total allowances against income, the balance of income is negative. This $(14,000) negative balance is allocated equally to the partners per their sharing agreement. This means that a negative $(7,000) is allocated to each partner. In this case, Zayn ends up with $32,000 and Perez with $18,000. If BOARDS had experienced a net loss, Zayn and Perez would share it in the same manner as the $50,000 income. The only difference is that they would have begun with a negative amount because of the loss. Specifically, the partners would still have been allocated their salary and interest allowances, further adding to the negative balance of the loss. This total negative balance after salary and interest allowances would have been allocated equally between the partners. These allocations would have been applied against the positive numbers from any allowances to determine each partner’s share of the loss.
Point: When allowances exceed income, the amount of this negative balance often is referred to as a sharing agreement loss or deficit.
Point: Check to make sure the sum of the dollar amounts allocated to each partner equals net income or loss.
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Point: When a loss occurs, it is possible for a specific partner’s capital to increase (when closing income summary) if that partner’s allowance is in excess of his or her share of the negative balance. This implies that decreases to the capital balances of other partners exceed the partnership’s loss amount.
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