A.

Course Code – Title : Accounting for Special Transactions

B. Module No – Title : MO1 – Partnership Formation
C. Time Frame : 1 week – 3 hours
D. Materials : Syllabus, Learning Plan, Curriculum Map, Writing
Materials, Accounting Standards and Books.

1. Overview
This learning material provides discussion of Partnership Formation concepts. It
introduces the learner to the subject, guides the learner through the official text, develops the
learner’s understanding of the requirements through the use of examples and indicates
significant judgements that are required in accounting for partnerships. Furthermore, the
module includes questions that are designed to test the learner’s knowledge of the concepts
pertaining to accounting for special transactions.

2. Desired Learning Outcomes

At the end of the learning session, you should be able to:
a. Define partnership.
b. Identify the attributes of a partnership.
c. Identify kinds of partnership and partners.
d. Determine contract of partnership.
e. Understand the concepts of partnership formation

3. Content/Discussion
PARTNERSHIP DEFINED
A partnership is an organization put up by two or more persons contributing money,
property or industry into a common fund with the purpose of dividing the profits among
themselves. (Article 1767 of the New Civil Code).

Persons forming a partnership include not only individuals but also partnerships,
corporations and other associations. Most often, partnerships are entered into by individuals
for the practice of a profession such as law, accounting, medicine and the like. Hence, we have
the ROBERT CARAG ONG & ASSOCIATES, architects; SIGUION REYNA MONTECILLO & ONGSIAKO
LAW OFFICES and the SYCIP GORRES VELAYO & CO., CPAs. Merchandisers, manufacturers and
distributors under a partnership form of business also abound. The partnership's name usually
ends with the word associates, company or & SONS.
Based on the definition given, the following are the elements of a partnership:
1. A valid contract, whether oral or written, is necessary. Article 1772 of the Law on Partnership
provides that when the capital is P3,000 or more, it must be in a public instrument; Article 1773
likewise provides for a written contract when the investment is in
the form of immovable property.
2. There must be two or more persons having legal capacity to enter into a contract.
3. Contributions may be in the form of money, property or service.
4. The purpose of the business is to divide the profits among themselves.

ATTRIBUTES OF A PARTNERSHIP
A partnership has both the attributes of a sole proprietorship and a corporation. Just like
a sole proprietorship, since it is an association of individuals, it involves accounting for each
partner's interest in the pooled assets. Since the business is generally managed by the partners,
they are therefore contractually liable to outside parties for transactions entered into by them.
Each of the partners has an unlimited liability over partnership debts. It means that their
personal properties can be subject to attachment by the partnership creditors when the
partnership becomes insolvent.

Since it is a legal entity just like a corporation, the partnership can enter into contracts to
acquire, hold or dispose properties. This attribute is in Article 1768 which provides that the
partnership is a separate distinct personality. As such, a clear distinction should also be drawn
between the net assets of the partners and that of the partnership and between personal
transactions of the partners and the business transactions entered into by them. The
partnership accountant analyzes and records only assets, liabilities, revenues and expenses
affecting partnership. Like a corporation, the partnership is a taxable entity subject to a 30 %
rate (effective 2009) unless it is a general professional partnership. Just like a corporation, a
partnership enjoys an indefinite life although the latter can easily be dissolved by the mutual
consent of the partners or when a partner retires or dies.

CHOOSING THE RIGHT FORM OF BUSINESS

If one is thinking of putting up a medium scale business where more capital is required
and the expertise of some friends or associates would be needed, then a partnership form of
business would be more appropriate compared to a sole proprietorship. Better management
would result because of the concerted efforts and abilities of the partners. Likewise, compared
to a corporation, it would be simpler and less expensive to form a partnership there being only
a few legal requirements. Additionally, partnership creditors are more protected than the
corporate creditors because of the unlimited liability requirement. It means that the partners'
personal properties may be subject to attachment in case the partnership becomes insolvent
and fails to pay its obligations.

On the other hand, because of more persons involved, conflict of interest is likely to
occur in a partnership which might adversely affect the business. Likewise, there is uncertainty
in its life. Although it is easy to put up a partnership, it is also easy to dissolve or liquidate it. The
mere withdrawal or death of a partner, especially if there are only two partners, would cause its
immediate dissolution.

KINDS OF PARTNERSHIPS
1. As to liability -
 A General Partnership is one where the partners are liable to the extent of their personal
properties. A Limited Partnership is composed of at least one general partner with the others as
limited partners whose liabilities do not go beyond their interest in the
partnership

2. As to properties -
A Universal Partnership of Property is one where all partners invest all their properties
into a common fund (Article 1778 of the New Civil Code), while a Universal Partnership of Profit
is one where the partners contribute all what they will receive as a result of their work or
service rendered by them during the lifetime of the partnership. Their individual properties do
not become partnership properties but are retained by them as personal properties.

KINDS OF PARTNERS
1. A general partner is one whose liability extends up to his personal properties and has the
right to manage the partnership.
2. A limited partner is one who is liable only up to his contribution in the partnership.
3. A capitalist partner is one who contributes money or property.
4. An industrial partner is one who contributes industry or service. He is also liable as a general
partner and is not allowed to engage in any other kind of business unless expressly authorized
by the other partners.
5. A real partner is an actual partner.
6. A nominal partner is a partner in name only.
7. An ostensible partner is one who is known to the public that he is a partner.
8. A secret partner is one who is not known as a partner to the general public.
9. A universal partner is one whose participation extends to the entire business venture.
10. A particular partner is one whose participation is limited to a unit or part of the business.

CONTRACT OF PARTNERSHIP
A basic requirement for registration of a partnership with the Securities and Exchange
Commission (SEC) is the filing of the Articles of Co-Partnership. The SEC is a government agency
tasked to supervise partnerships and corporations. The following information are contained in
the Articles of Co-Partnership:

1. Those affecting formation

a. Name of the partnership, its nature and location
b. Effective date of operation
c. Life of the partnership based on the accomplishment of its purpose or objective
d. Names and addresses of the partners
e. Initial asset contributions of partner and their monetary values
f. Initial interest of the partners and subsequent interest resulting from share in profit or loss.

2. Those affecting operation

a. Manner of management
b. Duties, rights and obligations of the partners
c. Limitations on withdrawals
d. Manner of dividing profit among partners
e. Arbitration of conflict

3. Those affecting dissolution

a. Manner of dissolving the partnership with the rights and duties of the partners
b. Manner of liquidating the partnership with the rights and duties of the partners
c. Date of closing the books and determination of profit or loss of the partnership
d. Manner of payment of liabilities and distribution of assets to the partners

In a partnership, where there are many persons involved, conflicts and disagreements
may easily arise. It is therefore advisable that a written contract be prepared. This will clear out
all points of activities in the business and will lead to a harmonious relationship among the
partners. The success of the partnership depends to a considerable extent on this premise.

PARTNER'S ROLE
A partner is a co-owner of the partnership property. Property invested by a partner such
as land or building ceases to be a personal property. It becomes property of the partnership. A
partner is liable to the partnership creditors individually and up to the extent of ones personal
properties. In the event that partnership assets are insufficient to pay for the liabilities, the
personal properties of a partner may be subject to attachment by the partnership creditors. A
partner is an agent of the partnership for the purpose of carrying its objectives. Therefore, the
partnership is bound by the act of a partner.

PARTNER'S INTEREST
Properties invested by the partners cease to be personal properties and become
partnership properties. However, as a partner, he is "co-owner" of the pooled properties an at
liquidation point has a right over these as represented by the partner s capital account. This is
called "right over assets". Likewise, profits obtained as a result of partnership operation should
be shared by all the partners based on some agreement. This is called "right over profits".
One must not assume that the right over the assets is computed the same way as the right over
profit or loss. The latter may have a different ratio depending on some factors and the partners'
agreement. Assume the statement of financial position of AB Partnership shows the following:
Assets P100,000
Liabilities 50,000
A, Capital 30,000
B, Capital 20,000

Agreed profit and loss ratio is 1:1. This shows that Partner A has a 60% (30,000/50,000)
right over the net assets but has a profit and loss ratio of 50%.

ACCOUNTING FOR A PARTNERSHIP

 The accountant is guided by the Articles of Co-Partnership in analyzing and recording
transactions. Information contained herewith is useful in recording the transactions. For
instance, after determining that a net income of so much was earned by the business, the
method of distributing the net income among the partners is provided in the articles. Whether
or not the partners can make cash withdrawals over and above their profit share or that only a
definite amount can be withdrawn in the form of salaries would depend upon the agreement
contained in the articles.
Basically, the same accounting steps are involved whether the business unit is a sole
proprietorship, partnership or corporation. Accounting for the interest of an owner or investor
is affected by the same factors such as investments, withdrawals and share in the net profit or
net loss. The difference in the accounting procedure lies in the closing of the net profit or loss.
In a sole proprietorship, the net profit is recorded in the drawing account which balance is
closed to the capital account. In a partnership, the net profit is recorded in the drawing
accounts of the partners based on an agreed ratio and the balances of the drawing accounts are
closed to the capital accounts as agreed upon by the partners. In a corporation, the net profit is
closed to an account title called retained earnings which is distributed to the shareholders as
dividends subject to the decision and declaration of a managing body called the Board of
Directors.

PARTNER'S CAPITAL AND DRAWING ACCOUNTS

Since a partnership is owned by two or more persons, it is necessary that there should
be as many capital accounts and drawing accounts as there are partners. For instance, assume
that there are three partners - Acosta, Bernabe and Cruz who put up the ABC Partnership. The
capital accounts are needed to record their investments: Acosta, Capital; Bernabe. Capital and
Cruz, Capital. Three capital account is used to record permanent changes in the partner’s
interest. Ordinarily, there are three items affecting this account – partner’s investment whether
original account if it is so agreed to make this part of permanent capital. A fourth factor may be
considered in the form of asset revaluation, when for example the partnership is to be dissolved
to make way for the reorganization of the partnership and the revision of the partner’s equity.

STATEMENT OF PARTNERS' EQUITY

For a simpler presentation of the statement of financial position, only the final balances
the partners' capital accounts are shown. A statement of partners' equity is prepared showing
all the changes affecting the partners' interests during the accounting period.

OTHER TRANSACTIONS AFFECTING PARTNER'S EQUITY

The following are variations to the investment or withdrawal made by a partner:
1. A partnership liability is personally paid by a partner.
2. Notes receivable of a partner is collected and retained by the partnership.
3. Partner's personal liability is paid out of partnership fund.
4. Receivable of a partnership is.collected and retained by a partner.

Whether the accountant should use the capital account or drawing account depends on
whether some transactions are to be considered permanent capital or temporary capital subject
to adjustment based on partner's profit share. Again, if after profit share the drawing account is
still a credit balance, this can be withdrawn by the partner or transferred to the capital account.

LOANS TO AND FROM PARTNERS

A partnership in need of additional funds may borrow from a partner. In this case a
liability account called Loan Payable to Partner is set up in the accounting records. The pro
forma entry will be:
Cash xxx
Loan Payable, Wency xxx
There are also instances where the partner borrows money from the partnership. In this case,
the partnership recognizes an asset Loan Receivable, Partner. The pro forma entry be:
Loan Receivable, Wency xxx
Cash xxx

PARTNERSHIP FORMATION
The first entries in the partnership books pertain to the contributions made by the
partners. The contribution may be in cash, property, industry or an already existing business. A
certified public accountant may assist the partners in revaluing the assets or in auditing the
books of a sole proprietor prior to forming a partnership.

If the contribution is in the form of industry or service, only a memorandum entry is

prepared. If the contribution is in the form of property, it should be recognized at the market
value or appraised value. Fair value is the amount for which an asset could be exchanged
between two knowledgeable and willing parties in an arm’s length transaction. Subsequently,
any gain or loss from its sale shall be shared by all the partners according to their profit and loss
agreement.

Liabilities attached to invested properties may be assumed by the partnership, in which

case the capital of the partner will be credited only at the net amount of the asset contribution.

To illustrate, assume that Vina, Carlo and Loy decided to form a partnership on July 1. Vina
agreed to contribute cash of P50,000 and merchandise costing P15,000 but with a present
market value of P10,000. Carlo agreed to invest land which was purchased for P75,000 but was
appraised at twice its cost price. Loy will be admitted as an industrial partner to share 10% in
the profits.
Opening entries in the partnership books –

July 1 Cash 50,000

Inventory 10,000
Land 150,000
Vina, Capital 60,000
Carlo, Capital 150,000
To record investments of Vina and Carlo.
July 1 Admitted Loy as Sales Manager to share 10% in the profits.
 Assume that the land to be invested by Carlo is currently mortgaged to a bank against a
loan payable with a balance of P50,000. If the partners agree that the liability will be assumed
by the partnership, then the entry to record the investment of Carlo will be:

July 1 Land 150,000

Mortgage Payable 50,000
Carlo, Capital 100,000
To record the investment and the liability assumed by the business.
Take note that the land is still recorded as P150,000. It is the capital account decrease with the
recognition of the mortgage liability by the partnership.

INVESTMENT OF AN ALREADY EXISTING BUSINESS

Where a partner has an already existing business and decides to invite another person
or persons to put up a partnership, two books will be affected, namely: the books of the existing
or old business and the books of the partnership. The following accounting procedures may be
followed:
1. Presentation of the assets and liabilities of the already existing business as the partner’s
investment.
2. Revaluation or adjustment of the assets and liabilities of the already existing business as
agreed upon by the partners.
3. Adjust the existing books based on no. 2 and close it.
4. Record investments at adjusted values in the partnership books.
In lieu of nos. 3 & 4, if existing books are still to be used, the following additional steps
should be accomplished:
● Adjust the existing books based on no. 2 and make an additional entry recording the
other partner's investment.

ACTUAL CONTRIBUTION AGAINST AGREED CAPITALIZATION

Most often, the actual contribution of a partner after adjustments becomes the basis of
the capital contribution in the partnership. A complication arises when the agreed capital credit
is not equal to his adjusted actual contribution. For instance: Acosta's actual contribution as
adjusted is P50,000. The partners agree to credit Acosta for P60,000. This is to entice Acosta to
join the partners especially if the talent/skill of Acosta is needed by the partnership. How will
the accountant recognize the difference? The partnership may record additional credit as a
goodwill or a bonus.

Bonus method. Under this method, the skill and expertise of Ant cannot be recognized as an
asset specially since there is no reliable measurement basis for this. Only the actual investment
of P50,000 can be recognized as asset. The other partners (Bug and Cat) may agree to adjust
their capital amounts (assuming each one contributed P50,000 each) and transfer interest to
Ant. Ant's capital will be credited for without making additional investment. The transfer of
capital of P10,000 received by Ant from Bug and Cat is called bonus capital. Total actual
contribution stands at P150,000. In table format, it will appear as follows:
Ant Bug Cat Total
Actual contributions P50,000 P50,000 P50,000 P150,000
Agreed Capital 60,000 45,000 45,000 150,000*
Bonus P10,000 (P5,000) (P5,000) 0

*Note that total agreed equity = total actual contributions and Acosta is credited for a P60,000
interest as agreed with a transfer of capital from the other two partners.

Journal entry will be:

Cash 150,000
Ant, Capital 60,000
Bug, Capital 45,000
Cat, Capital 45,000

Goodwill method. The assumption here is that two contributions are made by Ant: cash of
P50,000 and an intangible asset in the form of goodwill. What is goodwill? Goodwill is an
intangible asset representing ability to generate earnings more than what is normal or
expected. Factors such as a good reputation (such as an experienced marketer), or skill in a
particular line (fifteen years head of a manufacturing company), skills (Italian culinary expert).
The partnership will surely benefit from this and may bring in more customers and therefore
more earnings for the business. Effects on the accounting values if goodwill is recognized:
assets will increase (debit goodwill) and the partner's equity will also increase (credit partner,
capital). How much is the goodwill? Since the agreement calls for a capital credit of P60,000
when actual investment is only P50,000, then the difference will represent
goodwill.
In table format it will appear as follows:
Ant Bug Cat Total
Actual contributions P50,000 P50,000 P50,000 P150,000
Agreed Capital 60,000 50,000 50,000 150,000*
Bonus P10,000 - - P10,000
*Note that total agreed equity is greater that the total actual contributions.

Journal entry will be:

Cash 150,000
Goodwill 10,000
Ant, Capital 60,000
Bug, Capital 50,000
Cat, Capital 50,000

PAS 38 recognizes goodwill only as a result of an acquisition made by a reporting entity.

Partnership goodwill has no related acquisition cost since no funds have been spent to acquire
the goodwill. Partnership goodwill is rare in actual practice. The bonus method is more
acceptable as it is an adjustment only on the capital accounts and only actual contributions are
recognized. Or, instead of goodwill, if the investment of Ant is in the form of property, then it
should be revalued. For example an investment of an equipment with a cost of P50,000 made
by Ant and the partners agree to credit him for P60,000: debit equipment for P60,000 and
credit Ant, Capital for P60,000.
If goodwill is to be recognized but the amount is not stated in the problem, it is determined by
comparing the total net tangible assets (already revalued) contributed against the agreed
capitalization. If agreed capitalization is higher than the net tangible asset contribution, then
goodwill is to be recognized.

Summary:
FORMATION
Accounting Procedures:
1. Valuation of assets and liabilities contributed
Assets: Liabilities if assumed by the partnership:
a. Agreed values a. Agreed values
b. Fair values b. Present values/fair values
c. Cost/Book values

Liabilities assumed by the partnership will operate to decrease the contributed asset of the
partner in computing the contributed capital.

2. Re-alignment of capital balances

a. Goodwill method
b. Bonus method
c. Non-revaluation and bonus method

Capital contribution vs. Final Capital credit

Capital contributions (also called initial capital credit) represent the net assets invested by a
partner whereas final capital credit represents the agreed capital for a partner. Generally, capital
contribution equals capital credit. However, this may be changed by agreement of the partners.
When changed by agreement, the difference between capital contribution and agreed capital is
accounted either as:
1. Bonus – transfer of capital among the partner. Total contributed capital = total agreed
capital.
2. Goodwill – the difference is attributed to an unidentifiable intangible asset (outlawed by
PFRS 3 for external financial reports). Total contributed capital < total agreed capital.
3. Cash settlement

*Loans to Partner/Loans from Partnership = Partnership Asset

*Loans from Partner/Loans to Partnership = Partnership Liability

References
1. Manuel, Z.V. (2016). Advanced Accounting. Manila, Philippines: GIC Enterprises
2. Advanced Financial Accounting and Reporting review materials by Wency Giron