 Hello and welcome to this session. This is Professor Farhad and this session would look at partnership and this is part two of five and in this session we're going to look at income allocation and lost allocation. This topic is covered in advanced accounting and also covered on the CPA exam. I really like what would like to connect with my viewers, my followers, my subscribers. Please connect with me. I have a LinkedIn account. I'm very active on LinkedIn. I keep you up to date. Also, if you're a Facebook user, I have a Facebook page, accounting lectures. Definitely go to my YouTube and subscribe to my YouTube so you're always to get any updates. And I am on Twitter as well. So in this session, we're going to look at how partners allocate net income and net loss. Simply put, what is the overall idea? The overall idea is this. And I want you to think about Forrest Gump, okay? It's funny, but maybe it will make some sense. The partnership is a business. So they're going to generate revenues and they're going to incur expenses. And at the end of the year, they're going to have either a net income slash loss or a net loss. The question is what do we do with this net income and net loss? In Forrest Gump, what did Forrest Gump do? He split that 50, 50. Okay? So now we are going to look at various agreements between the shareholders on how they allocate this net income and net loss. Because as a partner, you're basically, you're going to be allocated part of the income. But how much of it will be allocated depends on the agreement. It could be a fixed ratio. This could be a fixed ratio. What is a fixed ratio? Basically a percentage. That's what a fixed ratio is. A fixed ratio is a percentage. Or it could be based on your capital balance. Well, what does it mean based on your capital balance? It means based on your contribution. How much are you contributing to this partnership? Okay? Or it could be based on the interest on capital investment. So let me just kind of look at some numbers here. For example, fixed ratio is we're talking about 6040. That's what a fixed ratio is. Based on capital balance, let's assume you contributed 100,000. The other partner contributed 100,000. That's total of 200,000. That's 50% and 50%. Or it could be based on interest on the capital investment. So basically, they're going to pay you interest based on your investment. It could also be some sort of a fixed salary allocation. And it could be a combination of all of those. I'm just showing you, you have different things. Or you could also have a bonus as a percentage of income. Or it could be a combination of all of those. So how you allocate income, it could be a combination of all of those. It could be just fixed ratio, depending on what you agreed upon. That's the whole thing. And the best way to illustrate this is to work actually an example. Because without working an example, this will remain basically theory. On January 1st, we have Tony and we have John formed TNG personal financial planning with capital investment 480 and 340 respectively. So Tony contributed 480, John contributed 380. The partnership agreement provide that profit and losses to be allocated as follow. So notice they have four levels of allocation. First, annual salaries of 42 and 66 are to be granted to Tony and John. John is entitled to a 10% bonus of net income after salaries and bonuses. But before interest and capital investment is subtracted, each partner is to receive an interest credit of 8% on the original capital investment. And any remaining profit is allocated 480 and 60. So this is basically a hierarchy of allocation. When you have a bonus situation, the first thing I suggest you do is to compute the bonus. And John is entitled to a 10% bonus of net income. Maybe John does a lot of work at the company and that's why they want to give them they agree to for John to get 10% income. So on December 31st, the partnership reported net income before salaries, interests and bonuses of 188. But the bonus is after salaries and the 10% bonus is after salaries and bonus, but before interest and capital. So we first we need to compute the bonus. So what is the bonus equal to? So how do we how do we set up the bonus? How do we set up the bonus? So let me show you how do we set up the bonus? Well, the bonus or saying the bonus, the bonus equal to 10% 10% times income before salaries, income, I'm sorry, income after salaries, not before salaries income after salaries, minus the bonus. Okay, so what do we know about income after salaries? Well, 10% will stay the same times. What is income after salaries? Well, we know that net income is 180,000 before salaries before salaries. So what is net income after salaries? It's 188 minus the salaries minus 42 minus 66. Okay, and that's open the bracket minus B. Okay, close the bracket. Okay, now what we have is we have 10% times 188 minus minus 108 equal to 80,000. So income after salaries is 80,000 minus B minus B. Then what we have now is 10% 10% my times 80,000 is 8,000 minus 10% times B is 0.1 B. That's all equal to the bonus bonus bonus. Okay, now what we have to do is we have 1B here. So what's going to happen is all we have to do is just rearrange, rearrange the formula. We have 1B here, and what I'm going to do, I'm going to add plus plus 0.1 B plus 0.1 B. And basically this 1B is gone. Now we have 1.1 B equal to 8,000. Now I'm just going to eliminate B. I'm going to take B and divide both sides by 1.1. Then the B, the bonus equal to 7,273. And this is how we compute the bonus. Now if you want to see if indeed the bonus is 7,273, well net income is 188. Salaries were 108,000. So we have to deduct salaries. And if we deduct the bonus, if the bonus is assumed to be 7,273, if we deduct the bonus, our net income is 72,000. That's subject to the bonus 727. If we multiply this by 10%, we'll give us this figure, which is kind of this is why we just confirm it that this is net income subject to the bonus. So our computation is correct, net income subject to bonus. So we figure out net income that's subject to bonus. Okay, let's go back to the PowerPoint slides. Now that we did the computation, the first thing is we compute the bonus. And with bonus is 7,273. Now we're going to start with the allocation. When we allocate, first we allocate the salary. So when you allocate, you go one, two, three, four, you go through this method. First we have, remember, we have 188,000. We're going to allocate 42 to Tony and 66 to John. So that's 108,000. Now what you do is basically you have left is one, and you started with 188, and you allocated 108. And whatever is left will be allocated. The next allocation level is the bonus. We're going to give John 7,273. Tony doesn't get a bonus. Okay, now we allocated an additional 7,273. And level three, what was level three? Level three, each partner to receive an interest credit of 8% of their original investment. So we'd look at their original investment multiplied by 8%. So, oops, sorry, for John, for Tony, it's 38,400. And now you might be asking, where does the 38,400 coming from? Well, Tony contributed 480,000. You multiply it by 8%. And Tony contributed 340,000 multiplied by 8%. And this is how we came up with the interest. So basically they want to be compensated for their capital. That's equal to 65,600. So, so far they allocated 180,873. What's left is 7,127. And how do we allocate this? We agreed to allocate anything left, 40% to Tony, 60% to John. Okay, so that's what's left. And at the end, you add up all of Tony's allocation, all of John's allocation. When you add them up, they should add up to 188,000. Let me go over this one more time. Let me go this real quick. So, first we started with the salary allocation. And what's left, then we allocate 7,273. Then we allocate the 38, the 27. And all in all, after we allocated those three, we allocated 188,73. And level four, it says anything that's left, what's left in income is this much. It's allocated 40 to 60. And when you add up all of Tony's, all of John, they should add up to 188,000. Okay, now what's the entry? Just kind of, in case you're wondering, what's the entry? Well, we're going to debit income summary, 188, credit, Tony capital and John capital for Tony for 83, 251. And this is a credit, 83, 251. And for John 104, 749. Okay, just in case you're wondering. Okay, so what happened sometime when we have insufficient income to cover the allocation? So we don't have enough income to go over the three or the four steps. It doesn't matter. We're just going to go through the process to allocate the income. So let me, we'll work an example amount by which salary and or interest exceeds net income is allocated to individual partners in their agreed ratio for allocating residual income. So just take a look at an example. Okay, for example, assume Adams and Brown agree to divide profit as follow. Adams to get a 4,000 salary, Brown to get 2,000 salary, 8% interest on the average capital balances of Adams, which is 77,500 Brown, 37,500 and any remainder to be divided equally. So let's see how it works. And let's assume for the sake of this illustration, we have 11,000 of net income. Well, first, we're going to allocate 4,000 and salary and 2,000 to Brown. So 11 minus 6, we are left with 5,000. Then it says allocate 8% under capital balances. Based on the 8%, Adams get 6,200 Brown gets 3,000. So notice what happened. We only have 5,000, 5,000 left, but we allocated 9,200. Okay, simply put, if we allocate minus 9,200, we are at a deficit of 4,200. Not a big deal. So just, we just keep going. The third option that says any access allocation, which is 4,200, negative 4,200 is divided equally, 2,100 negative, 2,100 negative. All in all, Adams gets 8,100, which is 4,000 plus 6,200 minus 2,100. Brown got 2,000 plus 3,005 minus 2,100 equal to 2,900. When we allocate the final, they should only equal to net income of 11,000. So if there is a negative, just keep going with the allocation process. That's what we are saying. Now, let's talk a little bit more about salaries and interest expense. Salaries and interest expense, salaries and interest, I'm sorry, they are not expense for the purpose of partnership. They are considered allocation of profit. So when I say we are going to be allocating a salary to Adams of 4,000 and to Brown of 2,000, those are not expense. So they don't go on the income statement. The same thing with interest. Because in a partnership, those are allocation of profit. So some change in capital account, as if salaries and interest were considered allocation of profit. So they do change, but they are not considered an expense. They do change the capital account. Why? Because if you allocate, they are going to increase the account. Since the normal practice is to recognize salaries and interest allocation of profit, any such amount, 3,000 expense should be adequately disclosed. So if you happen to treat them as an expense, you have to disclose this information. Why? Because in a partnership, when a partner takes a salary, it should not be an expense for the partnership. If you happen to treat an expense, make sure you disclose this. And the reason is, you want the reader to evaluate the performance of the firm. So simply put, when the company made 188,000 in net income, and the owner stuck out 108,000 in salaries, so what is the net income? What is the net income in that situation? Well, let's do this. Just going to show you how it works. 188 minus 108, oops, 188 minus 108, that's equal to 80,000. So did the partnership made $80,000 of profit? So if I'm investing in this partnership, should I say the partnership is making 80,000 of profit, or should I consider the partnership is making 188? Well, if the partners are taking the salary up front, then guess what? The partnership is making 80,000 because although it says 188,000, but the first 108,000, it's not really mine. So if you treat it as an expense, I need to know. If you're treating it as a withdrawal, I need to know. If you're treating it not as an expense, it's an allocation to income, I need to know. So that's why it's important to remember this concept. Adjustment to net income, what happened is sometime you might have errors in the prior year, problems and allocation of profit and loss can result if errors are discovered that occur in a specific prior year and partners have altered profit and loss agreement since the period in which the error occurred. So when you have an error, what do you have to do? Well, guess what? You cannot go back to prior years, what you have to do, you have to allocate the error to the capital account. So you just have you compute the error and you allocate it to the partners capital account, whether it's, it's going to increase or decrease depending on the error itself. Some differences from gap. Changes in partners equity should be disclosed. So you need to disclose this. Remember, salary allowances are generally not expense. And if they are expense, you need to disclose them. There's no income tax expense for a partnership because the profit goes to the partners and the partner's base income. Interest allowance on capital investment is considered allocation of profits. When we compute that interest allowance and what is the interest allowance? What we are saying is this, the partner saying we made an investment, we invested $100,000 of our own money. Well, we need to be compensated at 10% because we invested this money, $10,000. Well, you cannot consider the 10,000 as an expense. It's an allocation of profit. Okay. That's what we are saying. Okay. And why do you, again, you're going to get a salary because you are working for the, for the, for the partnership. That's why you have a salary allocation. Then you also want to get an interest income because you invested your money. So you're investing your time, you'll be compensated with the salary. So basically, if you really think about it, just kind of hopefully it will make more sense to you. Why do we have all these levels of allocation? The various level is, for example, one is because you work there. You're working at the partnership, you're investing time. Two, maybe you have a bonus because you have some special skills. Three, because you invested your capital. You invested your capital and you want to be compensated for that money. So you're given money and time. Well, you're being compensated for your time, but you also want to compensate it for your money. Okay. So that's why we have different type of compensation level to basically properly capture what's really happening. Okay. Again, this is an agreement between the partners themselves. And this is a statement of changes in partners capital for the year. And basically, this is for Tom and Julie from the prior session. So if you look at the prior session, this should make sense. They started this partnership. Therefore, their beginning capital is zero on January 1st. Then they made an investment. Tom invested 51. Julie invested 25, a total of 76. Net income allocated for Tom was 33,553. Net income allocated to Julie was 16,447. And what's going to happen? This income will be added to their capital. Then we subtract any withdrawals. Tom took 12,000. Julie took 15. Julie took 12. And this is the ending balance of their capital account. And this is the ending balance for the whole partnership, 99,000. Basically, you looked at how do we allocate income for a partnership. If you're studying for your CPA exam, study hard. If you happen to visit my website for additional lectures, I do encourage you to do so. Please consider donating. If you have any questions, email me. Study hard for the exam. It's worth it.