PARTNERSHIP

Accounting for partnerships

The Conceptual Framework for Financial Reporting and the Standard (or PFRS for SMEs, when
appropriate) are applicable to all reporting entities regardless of the type of organization. Thus, most
accounting procedures used for other types of business organizations are also applicable to partnerships.
The main distinction lies on the accounting for equity. In addition, the accounting for partnerships should
also comply with relevant provisions of the Civil Code of the Philippines.

The following are the major considerations in the accounting for the equity of a partnership:

a. Formation - accounting for initial investments to the partnership

b. Operation - division of profit or losses
c. Dissolution - admission of a new partner and withdrawal, retirement or death of a partner
d. Liquidation - winding- up of affairs

Formation
A contract of partnership is consensual. It is created by the agreement of the partnership which may be
constituted in any form, such as oral or written.

Division of profits and losses

The partner shall share in the profits or losses of a partnership in accordance with the partnership
agreement.

Art 1797 of the Philippine Civil Code provides the following additional rules in the profit or loss sharing of
partners:
If only the share of each partner in the profits has been agreed upon, the share of each in the
losses shall be in proportion to what he may have contributed. but the industrial partner shall
not be liable for the losses. As for the profits, the industrial partner shall receive such share as
may be just and equitable under the circumstances. If besides his service he has contributed
capital, he shall also receive a share in the profits in proportion to his capital.

The designation of losses and profits cannot be entrusted to one of the partners (Art. 1798). A stipulation
which excludes one or more partners from any share in the profits or losses is void (Art 1799).

In addition the partnership agreement may also stipulate the following:

a. Salaries - normally, an industrial partner receives salary in addition to his share in the partnership’s
office as compensation for his services to the partnership.

b. Bonuses - the managing partner may be entitled to a bonus for excellent management performance.
Unlike for salaries, a partner is entitled to a bonus only if the partnership earns profit. The partner is not
entitled to any bonus if the partnership incurs loss.

c. Interest on capital contributions - the partnership agreement may stipulate that each partner is
entitled to a per annum interest computed on his capital contributions.

Dissolution
As mentioned earlier, one of the characteristics of a partnership is that is has a “limited life,” in the sense
that the partnership agreement can be easily dissolve.

Dissolution is different from liquidation. Dissolution is the change in the relation of the partners cause by
any partner ceasing to be associated in the carrying on of the business. Liquidation is the termination of
business operations or the winding up of affairs.

Partnership dissolution does not necessarily terminate the business. The business continues until the
remaining partners decide to liquidate the business. If the business is continued after dissolution, new
articles of partnership should be drawn up.

The following are the major considerations in the accounting for partnership dissolutions.
a. Admission of a partner.
b. Withdrawal, retirement or death of a partner
c. Incorporation of a partnership
The admission of a new partner or the withdrawal, retirement or death of an existing partner dissolves
the original partnership agreement because it creates a change in the relation of the partners (e.g., a
change in the number of the partners in a partnership).

It should be noted that the admission of a new partner requires the consent of all the existing partners.

Admission of partner
The admission of a new partner may be effected either through:
a Purchase of interest in the partnership, or
b Investment in the partnership.

Purchase of interest
A new partner may be admitted when he purchases part or all the interest of one or more of the existing
partners.

This transaction is a personal transaction between and among the partners. As such, any consideration
paid or received is not recorded in the partnership books. The only entry to be made in the partnership
books is a transfer within equity. A new capital account is established for the new partner and a
corresponding decease is made on the capital account(s) of the selling partner(s). No gain or loss shall is
recognized in the partnership books.

Revaluation of asset
When a partnership is dissolve but not liquidated, a new partnership is created. The asset and liabilities
carried over to the new partnership are restated to fair values.

Any adjustments to the asset and liabilities is allocated first to the existing partners before recording the
admission of the new partner.

Investment in the partnership

Instead of purchasing interest from the existing partners, a new partner may be admitted by investing
directly in the business.

This transaction is a transaction between the new partner and the partnership. As such, any
consideration paid by the incoming partner shall be recorded in the partnership books. However, since
this is a transaction with an owner, no gain or loss shall be recognized.

Two things may happen when a new partner invests in a partnership:

1. The new partner’s capital account is credited at an amount equal to the fair value of his investment;
or
2. The new partner’s capital account is credited at an amount greater than or less than the fair value of
his investment.

Incorporation of partnership
There are various reasons for incorporating a partnership, which may include the following:
a. Limited liability of shareholders - shareholders are not liable to corporate creditors beyond their
investment in the corporation.
b. Ease of raising additional capital - greater capital can be raised from an increased number of owners.
Also, it is easier for a corporation to generate external financing, as lenders need not worry about the
death of the partners.
c. Privacy and confidentially - unlike in partnerships, the owners of a corporate are not agents of the
corporation.
d. Dispersion of risk - the risk of loss is dispersed to more owners.
e. Unlimited life - changes in the relationship of the owners of a corporation do not dissolve the
corporation.
f. Transferability of ownership - transferring an ownership in a corporation is made simply by selling
one’s share stocks. The corporation need not to be dissolved when a shareholder sells his interest in the
business.
g. Better public relations - many believes that wider ownership of a business results to better public
relations.

When a partnership is converted into a corporation, the corporation acquires and assumes the assets and
liabilities of the partnership in exchange for shares of stocks which shall be issued in settlement of the
partners’ respective interests.
Liquidation
Liquidation is the termination of business operations or the winding up of affairs. It is a process by which
1 the assets of the business are converted into cash,
2 the liabilities of the business are settled, and
3 any remaining amount is distributed to the owners.

Liquidation may either be voluntary (e.g., per agreement of partners of a solvent partnership) or
involuntary (e.g., per government mandate or bankruptcy).

Conversion of non-cash assets into cash

The conversion of assets into cash is referred to as “realization” while the settlement of claims or
creditors and owners is referred to as “liquidation”. However, the term liquidation is used in a broader
sense to include the entire winding up process.

The winding up process starts with the conversion of non-cash assets into cash. As such, the timing of the
“realization” of non-cash assets determines the manner on which the “liquidation” (i.e., payment of
claims) is carried out.

Methods of liquidation
Liquidation may be accomplished either through.
1. Lump-sum liquidation- all of the non-cash assets of the partnership are sold simultaneously or
within a very short period of time. The proceeds are then used to settle all of the liabilities first, and any
remaining amount is paid to the partners under a single, lump-sum payments.

Lump-sum liquidation is possible when there is a contracted buyer of all of the non-cash assets of
the partnership or the assets are sold on a “package deal” basis.

2. Installment liquidation - is most cases, it would take some time before all of the assets of a
business are converted into cash. In such case, the partners’ claims are settled on installment basis as
cash becomes available, but only after all partnership liabilities are fully settled.

Settlement of claims
The available cash of the partnership is used to settle claims in the following descending order:
1. First, to outside creditors;
2. Second, to inside creditors (e.g., payables to partners);
3. Third, to owners’ interests

Right of off-set
As shown above, a loan payable to a partner has a higher priority over the partner’s capital balance but a
lower priority over the claims of outside creditors. However, the legal right of offset allows a deficit in a
partner’s capital account to be offset by a loan payable to that partner.

Lump-sum liquidation vs. Installment liquidation

The following procedures shall be observed when accounting for lump-sum liquidation or installment
liquidation:
Lump-sum
1. All of the non-cash assets are converted to cash.
2. The total gain or loss on the sale is allocated to the
partner’s capital balances based on their profit or loss
ratios.
3. Actual liquidation expenses are allocated to the
partners’ capital balances based on their profit or loss
ratios.
4. The liabilities to outside creditors are fully settled.
5. The liabilities to inside creditors are fully settled.
6. Any remaining cash is distributed to the owners in full
settlement of their interests.
Installment
1. Some of the non-cash assets are converted to cash.
2. The carrying amount of any unsold non-cash assets is
considered as a loss. This is allocated to the partners’
capital balances based on their profit and loss ratios.
3. Actual and estimated future liquidation expenses are
allocated to the partners’ capital balances based on their
profit or loss ratios.
4. The liabilities to outside creditors are partially or fully
settled.
5. The liabilities to inside creditors are partially or fully
settled but only after settlement of the liabilities to
outside creditors.
6. If both the liabilities to outside and inside creditors
are fully settled, any remaining cash less cash set aside
for future liquidation expenses is distributed to the
owners as partial settlement of their interest.
Marshalling of assets

As mentioned earlier, one of the characteristics of a partnership is ‘unlimited liability”. This is because the
personal assets of the general partners are subject to the claims of partnership’s creditors in case of
partnership insolvency.

The legal doctrine of marshalling of assets is applied when the partnership and some of the partners are
insolvent. The following are the rules when applying this doctrine:
1. First, any available assets of the partnership is used to settle the partnership’s liabilities.
2. Second, in case the assets of the partnership are insufficient to pay all liabilities (i.e., insolvency), the
solvent general partners are required to provide additional funds their personal assets.
The claims to the personal assets of a partner shall rank in the following order:
a. Those owing to separate creditors.
b. Those owing to partnership creditors.
c. Those owing to partners by way of contribution.
3. Third, in case some partners are insolvent (or limited partners), their capital deficiency shall be offset
to the capital balances of the other partners. If after allocating the capital deficiency of an insolvent (or
limited) partner, a solvent partner’s capital balance result to a negative results to a negative amount, the
solvent partner is required to provide additional contribution.

Cash priority program

Another method of ensuring that there are no overpayments to partners is by preparing a “cash priority
program” or “cash distribution program.” This schedule determines which partner shall be paid first and
which partner shall be paid last, after all liabilities are settled. This schedule can be prepared even prior
to the sale of any asset.

The preparation of this schedule requires the application of the same concepts as those we have applied
earlier, namely:
a. Unsold non-cash assets are treated as loss; and
b. Expected future liquidation costs and potential unrecorded liabilities are recognized immediately as
losses.

An additional procedure when preparing a cash priority program is to rank the partners in accordance to
their maximum loss absorption capacity. The partner with the highest maximum loss absorption capacity
shall be paid first. The partner with the lowest maximum loss absorption capacity shall be paid last. The
formula in computing for the maximum loss absorption capacity is as follows:

Maximum loss Total partner’s interest in the partnership

absorption = Partner’s profit or loss share percentage
capacity