Question

Please explain how participation income and expenses are allocated to each partner. Where is this defined?

Answer 1

Answer :

A partnership is an unincorporated business arrangement among two or more partners. Partnerships are not subject to income taxes. The profit or loss is allocated to each partner at the end of the year, and this allocation determines the partners' taxable income. Each partner gets an equal allocation unless the partnership agreement specifies otherwise. The first step in preparing a partnership income statement is to determine the net income or loss and then allocate it using one of three allocation methods.

Net Income Calculation and Closing Entries

• Add the revenues from all sources, such as product sales, service revenues and interest income.
• Determine the total expenses for the accounting period, including salaries, rent, utilities and marketing.
• Subtract expenses from revenues to calculate the net income for the period. There is a net loss if expenses exceed revenues.

Prepare the closing entries, which close and zero out income statement accounts at the end of an accounting period to a temporary income summary account. Close the revenue and expense accounts to income summary. Debit revenues and credit income summary, and credit expenses and debit income summary. The resulting balance in income summary is the net income or loss for the period.

Ratio-Based Allocation

Allocate the net income based on a predetermined ratio. For example, if the partnership agreement among three partners specifies an equal allocation, then each partner gets a third of the net income or loss for an accounting period.

Determine the net income allocation using the beginning or average capital balance. For example, if two partners have beginning balances of $10,000 and $15,000, then the allocation ratio is 0.40 [$10,000 / ($10,000 + $15,000) = $10,000 / $25,000 = 0.40], or 40 percent, and 60 percent (100 - 40). If the net income is $1,000, the partners get $400 and $600.

Debit and zero out income summary, and credit the capital accounts of each partner by their respective income or loss allocations.

Combination Method: Salaries, Capital and Ratio-Based Allocation

Distribute salaries to partners based on a partnership agreement. This method of income allocation uses salaries, capital contributions and fixed ratios to allocate income. For example, if a partnership with a net income of $20,000 decides to pay its two partners $8,000 and $5,000, then $7,000 ($20,000 - $8,000 - $5,000) remains after the salary payments.

Allocate income or loss based on a fixed percentage of the beginning or average capital balances. Continuing with the example, if the partners had $5,000 and $7,000 as the beginning capital balances and they have agreed to a 5 percent allocation of these balances, each partner receives an additional $250 (0.05 x $5,000) and $350 (0.05 x $7,000), respectively. The remaining net income balance is $6,400 ($7,000 - $250 - $350).

Allocate the remaining net income according to the ratio specified in the partnership agreement. Continuing with the example, the allocation of the remaining net income balance to each partner is $3,200 ($6,400 / 2), assuming that the partners have agreed to share the balances equally.

Add the salaries, capital and remainder allocations to calculate the total net income allocation for each partner. To conclude the example, the net income allocation for each partner is $11,450 ($8,000 + $250 + $3,200) and $8,550 ($5,000 + $350 + $3,200). The journal entries are the same as the ratio-based methods.