 Hello, and welcome to this session. This is Professor Farhad. In this session, we would look at allocating income and losses among partners. This topic is covered in financial accounting as well as in advanced accounting. I do have it covered in advanced accounting as well in a more advanced fashion. This topic is also covered shortly on the CPA exam, the FAR section. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, finance, and Excel tutorial. If you like my lectures, please like them, share them, put them in playlists, subscribe to the channel. If it helps you, it means it might help others. So share the wealth, connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to supplement your CPA examination or your accounting courses. If you're looking to improve your performance on the CPA exam, please check out my website. I can help you earn those 10 to 15 extra points to get the CPA behind you. What we're gonna be looking at today is dividing partnership income or loss. So simply put, when a partnership makes a profit, so let's assume we are looking at a partnership that made a profit of $100,000. This is the revenues, and we're gonna assume expenses of 60,000. So the partnership made a profit of $40,000. What do we have to do at the end of the period? So we're gonna keep it simple. We're gonna split this profit 50-50. So 20,000 goes to one partner, and we have two partners, and 20,000 goes to the other partner. Now I hope you remember how to do the closing entries. If not, I'm gonna go over this real quick. Let me show you real quick the closing entries that you learned in earlier chapter because you will be needing those closing entries today. So in other words, if you don't know how the closing entries work, I'm gonna give you a quick tutorial using this example that I just used. So if you have revenues of 100,000, what you need to do, revenues is a credit balance of 100,000, and we have all sorts of expenses, and expenses, they do have a debit balance. So what we need to do first, we need to close revenues. So how do we close revenues? We are going to debit revenues, 100,000, to close it down to zero, and we're gonna, for revenues, we're gonna transfer this account to income summary. So we're gonna debit revenues, credit income summary, and what we did is we transferred the 100,000 to this account. Now we're gonna have to do the same thing with expenses. We're gonna, I'm gonna use a different color, we're gonna credit expenses of 60,000, make the expenses go down to zero, and move the 60,000 to income summary. Now what happened is we have 40,000 in income summary. Now from this income summary, this 40,000, this is the profit, remember we have $40,000 in profit. So the profit sits in income summary, then the profit will be distributed, in quote, distributed to each shareholder. So what's gonna happen, we have two partner, we have partner with the name Adam, and partner with the name, my name, Mansour. So we have two partners, and what's gonna happen is, we're gonna credit Adam's account, 20,000, we're gonna credit the capital account of my name Mansour, 20,000, and we're gonna debit income summary. So what we do is we debit income summary, 40,000, therefore income summary goes down to zero, and this is the entry to allocate the profit to 50% to Adam, and 50% to my account Mansour. So in this session, we're gonna be, they're gonna be giving you income summary. The reason I went through this is to kind of remind you how income summary work. This is how we get to income summary. Now also we close the withdrawal to the capital account, but we'll see that later. So simply put, partners are not employees. So if you're a partner, you're not an employee, you are the owner of the business. So you cannot have salary expense to yourself. So you cannot report yourself as a salary expense because you are the owner. No salary expense is reported. Profit and losses of the partnership are divided among some agreed upon ratio. So here I assumed between Adam and Mansour 50-50. Now that's not the case. You could do it 50-50, or you could do it in any form such as any stated ratio. Like when I said 50-50, this is a stated ratio. The ratio could be 70-30. The ratio could be anything. Okay, 60-40, it has to add up to 100. So stated ratio is one of them. Capital balances, for example, if I contributed 50,000 and Adam contributed 10,000, well, guess what? What is our capital balances? The total is 60,000. I contributed five six and Adam contributed one six. So what we do is when we distribute the profit, five six goes to me and one six goes to Adam. This is based on the capital contribution. And the third allocation, we could use a combination of services, how much time you invest in the partnership, capital contribution, how much money you invested and some sort of a stated ratio, which is a combination. And we're gonna be looking at all three examples to illustrate this concept. Starting with stated ratio. It's pretty straightforward. In a partnership agreement, we have Zane is to receive two-third and Paraz is one-third of the partnership income and loss. If the partnership income is 60,000, what's gonna happen? Two-third, which is almost 66% and one-third goes to Zane. Simply put, two-third is 40,000 and one-third is 20,000. Therefore, we increase Zane's capital 40. We increase Paraz's capital 40 and we debit income summary. But you know where the income summary came from. Income summary came from revenues and expenses. Let's take a look at capital balances. Remember, another way to allocate the profit is based on their capital balances. Zane and Paraz agree to allocate their profit based on their beginning capital balances. So what's their beginning capital balances? Well, let's assume that this is the beginning capital balances. Zane contributed 30,000, Paraz contributed 10. So Zane 30, Paraz is 10. They add up to 40,000. Now we need to find the ratio. Three divided by four or 30,000 divided by 40,000 is 75%. What's gonna happen? Zane gets 75% of the profit and Paraz gets 25% of the profit. Therefore, we'll take 75 times 60. 45,000 is allocated to Zane and 15,000, which is 25% of 60 is allocated to Paraz. Why did we do so? Because they wanted to share the profit based on their beginning capital balances. How much you contributed? And remember, you look at the beginning of the period, beginning of the period capital balance. Because this is the beginning, and if I ask you, what is the ending balance of Zane? Well, Zane started with 30,000. Then Zane increased their balance by 45. Zane's balance now was 75. If I ask you, what is Zane's ending balance? And we'll do the same thing with Paraz. Started with 10, increased by 15. Their balance is 25,000. This is the ending balance. And this ending balance will be the beginning balance of next year. So next year, their capital ratio, if they did not make any withdrawals, because remember, if you make any withdrawal, you reduce your capital ratio, their beginning balance is any profit will make next year. Paraz will get 25% and Zane's get 75%. Why? Because 25,000 plus 75,000 equal to 100,000, 25 over 100 is 25 and 75 over 100 is 75. But that's for next year. The third contribution, we can use a combination of services, capital and stated ratio, something to that effect. So here's what they agreed upon. Zane to receive 36,000 annual salary. Remember, this is not a salary expense. Basically, this is what we call this a withdrawal or a guarantee payment. Paraz to receive 24,000. So this is what they agreed. So this is what they do. Maybe Zane's put more time into the partnership and they want to live, therefore they have to take 36,000. Paraz is putting less time, therefore we'll get 24,000. Anything remaining, I'm sorry, that anything remaining, each partner is allowed an annual interest of 10% of their beginning capital. Simply put, what they're saying is the money that you invested, we have to compensate you and we're gonna compensate you for 10% because you have some money invested. And anything that's left is allocated equally between the two partners. So let's take a look at an example to illustrate this concept. So let's see how we allocate this 70,000. Well, remember, the first thing we agreed upon is Zane gets 36,000 salary allowance, Paraz gets 24. So of the 70,000, we allocate 36 to Zane, 24 to Paraz, what's left of the 70,000 is 3,000. Then the second level is each one of them get 10% of their capital contribution. Zane contributed 30,000 of capital, that's 10%, and Paraz contributed 10,000 of capital, that's times 10%. And this is where we got these figures from 30,000 and 10,000. So 3,000 is allocated to Zane, 10,000, 1,000 allocated to Paraz. We subtract from the 10,000, we're left with six. Now anything remaining is allocated equally, equally means 50, 50, 3,000 and 3,000. So simply put, we allocate 42,000 to Zane, 28 to Paraz. Now the journal entry obviously is credit Zane's capital 42, credit Paraz's capital 32 and debit income summary. Now let's assume the income is only 50,000. What's gonna happen is this, we're gonna follow the same formula, but here we might have a negative balance. So how do we deal with this negative balance? First we allocate based on salaries, 36,000 to Zane or allowance and 24,000 to Paraz. That's gonna give us a remainder of 10,000. You don't stop, this is an allocation process. You have to keep on allocating until you follow all the formulas. Now remember, 10% of 30,000 is 3,000, 10% of 10,000 is 1,000. Now we have a deficit of 14,000. Now this deficit will be allocated equally to get root of the negative 14,000. So we're gonna allocate 7,000, negative 7,000 to Zane, negative 7,000 to Paraz. Now we net them out, Zane gets 32,000, Paraz gets 18 and together they equal to 50,000 of the net income that we wanted to allocate in the first place. Let's take a look at the what's called partnership financial statement. During 2016, Zane withdrew 20,000 of cash and Paraz withdrew 12,000. And let's assume we did the allocation based on the $70,000 net income. So now we're gonna prepare the complete financial picture of the partners. When they started the year, we did not have the partnership, therefore the beginning balance is a zero. Zane contributed 30,000, Paraz contributed 10,000. That's the beginning of their capital balances. Then we allocated the profit of 70,000 based on salary, interests and any remaining balance. And here's what we did earlier. So we allocated 42 to Zane and 28 to Paraz, notice total of 70. Then Zane withdrew 20,000. We're gonna deduct it from Zane's capital and Paraz withdrew 12,000. We're gonna deduct it from Paraz's capital. Now the ending balance for Zane is 52,000 and the ending balance for Paraz is 26. And the partnership has capital of 78,000 in total. So notice what we did here. We added the partners withdrawal. Now what is the entry for the partners withdrawal? Simply put, we're gonna credit cash. We're gonna credit cash for 20,000 for Zane. And we're gonna debit the withdrawal account. We're gonna have withdrawals for Zane and that's gonna be a debit of 20,000. So this is the entry. Now, so let's take a look at this example to illustrate this concept. Merkel and Putin began the partnership by investing 6,000 and 4,000 respectively. So simply put, Merkel invested 6,000, Putin invested 4,000, so this is the credit and the debit will be the cash, kind of if you're interested where the debit goes. The debit is to cash, but we're only looking at the capital account. During the first year, the partnership earned $80,000. Prepare calculation showing how the 80,000 is allocated to the partner under each of the following three separate plan for sharing income and losses. The partners fail to agree on a method to share income. Now what we are saying here is we have 80,000 of income summary. That's what we're saying. How are we gonna allocate this income summary? Now we have to be very careful here. There is a tax, there is a tax requirement or is a financial accounting. Now for taxes, I'm not gonna deal with taxes. If we fail to agree, then it's gonna go 50, 50. So simply put, this 80,000 will be allocated 50, 50 because they fail to agree or the investment asylum. Now for tax purposes, there's a new rule that it doesn't go with 50, 50, it's based on the capital contribution. But since this is not a tax course, we're gonna follow the financial account. And obviously 50, 50 will give 40,000 for each partner. So basically the allocation is equal, 50, 50, okay? So 40,000 to Merkel, 40,000 to Putin and Putin. And this is how we prepare the journal entry on December 31st, which is debit the income summary, 80,000 credit the each of the respective capital, 40,000 and 40,000. Let's take a look at it from a T account. So notice the income summary is debited goes down to zero. Now the Merkel account is 46,000 and Putin account is 44,000. So this is the first allocation since they fail to mention an agreement, okay? So now in the second scenario, the partners agree to share their income and loss in proportion of their initial investment. Remember, six plus four equal to 10. So we have 6,000 and 4,000, that's 10,000. Merkel will get 60%, Putin will get 40%. So we're gonna take the 80,000 multiplied by these ratios. Simply put, 80,000 multiplied by 60%, Merkel gets 48, 80,000 multiplied by 40%, 32,000. Again, 48 goes to Merkel, 32 to Putin and this is how we allocate them. We credit their capital account by the amount and we debit income summary for 80,000. Now what's the new balance? Notice the income summary goes down to zero. The new balance for Merkel is 54 and for Putin will allocate the income of 32, which will give it 36,000. Let's look at a third scenario where the partners agree to share the income by granting 38,000 per year annual allowance to Merkel, 13,000 allowance to Putin, 20% interest on their initial capital investment in any remaining balance is split 70 to 30. So starting with the 80,000, first we allocate the salary allowance 35 and 15, what we remain is 48. Now if the remain is negative, you keep on going. It doesn't matter because at the end, you'd allocate the negative against the positive but now it's still positive. Interest allowance, 6,000 times 20% to Merkel, that's 1,200. 4,000 times 20% is 804 Putin, that's $800 and 1,200. Again, what's left is you have to reduce this, you have these amounts reduce the remaining balance, which is now we'll remain the, now we have, we are down to 30,000 because now we allocated 50 and anything left, which is 30,000 is split 30 to 70. 70% of 30,000 is 21,000, 30% is 30% of 30,000 is nine and now we are left with nothing, we allocated everything, the remaining balance is zero of the income. Now we add up, we add up those and 57,200 goes to Merkel, 22,800 goes to Putin and here's the journal entry to allocate this income. Basically we credit their capital and we debit income summary because we need to close income summary. So income summary is closed, credit the capital balance. If you like this recording, please like it, share it, put it in playlist. I always I would like to remind you to visit my website for additional resources. If you're looking to supplement your accounting education or pass your CPA exam, you invest in your education once in your lifetime, make it properly, good luck, study hard, accounting is worth it and the next session would look admission and withdrawal of partners. Good luck and stay safe, especially during those coronavirus days.