Partnership Formation

• A partnership is an association of two or more persons who contribute money,

property, or industry to a common fund with the intention of dividing the profits among
themselves.
o The term “person” refers to either a natural or juridical person.
• One of the major advantages of a partnership is that it permits the pooling of capital
and other resources without the complexities and formalities of a corporation. In addition,
the partners operate with more flexibility because they are not subject to the control of a
board of directors.

• There are two types of partnerships:

A. General Partnership- each partner is personally liable to the partnership’s

creditors if partnership assets are insufficient to pay such creditors; partners are called
general partners
B. Limited Partnership- only one partner needs to be a general partner while the
remaining can be limited partners; the limited partners’ personal properties are not put
to risk, and they play no role in the partnership management
Features of a General Partnership
1. Ease of formation- partners merely put their agreement on contribution, roles,
functions, P/L distribution into writing called partnership agreement
2. Limited Life- the possibility that the partnership operation may discontinue after a partner’s
withdrawal or death is considered a major pitfall
3. Assignment of Partner’s Interest- assignment of a partner’s interest does not
automatically dissolve a partnership; the assignee has no right to participate in the managing
affairs and they are only limited to their allocation of P/L
4. Unlimited Liability- partnership creditors may demand from any partner who was personal
assets in excess of personal liabilities
5. Mutual Agency- every partner is an agent and has the authority to act for the
partnership and to enter into contracts on its behalf
6. Separate Legal Personality- a partnership has a juridical personality separate and
distinct from that of the partners
7. Sharing Profits and Losses- P/L are divided among the partners in any manner to which
they agree

Underlying Equity Theories

- Relate to how an entity can be viewed from the accounting and legal POV

A. Proprietary Theory- views the assets and liabilities as belonging to the proprietor and the
profits as increase in the proprietor’s capital; characteristics include:
o Salaries to partners are considered as distribution of income and are treated as
expenses in computing net income

o Unlimited liability of general partners extend beyond the entity to the individual
partners

o Original partnership is dissolved upon the admission or withdrawal of a partner

 B. Entity Theory- views the business as a separate and distinct entity possessing its own
existence independent from the individual partners; the legal life of the firms transcends the
death or admission of a partner

Written Partnership Agreement

- A written agreement is called the articles of partnership and contain the following:

1. Name of the partnership

2. The name, addresses of the partners, classes of partners, stating whether the partners
are general or limited

3. The effective date of the contract

4. The purpose/s and principal office of the business

5. The capital of the partnerships stating the contribution of the individual partners, their
descriptions and agreed values

6. The rights and duties of each partner

7. The manner of dividing net income or loss among the partners including salary allowance
and interest on capital

8. The conditions under which the partners withdraw money or other assets for partnership use

9. The manner of keeping the book of accounts

10. The causes of dissolution

11. The provision for arbitration in settling disputes

- General-purpose financial statements should use generally accepted accounting principles

(GAAP) as promulgated by the International Accounting Standards Board (IASB) and other
standard-setting bodies.

- For internal reporting needs, the FS should meet the information needs and the
partnership may use non- GAAP accounting methods and have the FS in different formats.

PFRS for Small and Medium-Sized Entities

• Small and Medium-Sized Entities are those that:

o Do not have public accountability

o Publish general-purpose financial statements for external users

Accounting for Partnership Activities

A. Capital Accounts
o initial investment of each partner is recorded by debiting the assets contributed, crediting
any liabilities assumed by the firm, and crediting the partner’s capital account of the fair value
of the net assets contributed

o equity is increased by additional investments at fair value at the time of investment and any
share of net income

o equity is decreased by withdrawal of cash or other assets and share of net losses

- withdrawals of large and irregular accounts are charged directly to the capital
account with the entry:
A, Capital

Cash

o at the end of the accounting period, the net income/loss in the Income Summary ledger
account is transferred to the partner’s capital accounts in accordance with the partnership
contract

o a partner’s capital account may have a debit balance (deficit) which can be eliminated
through additional contributions

B. Drawings or Personal Accounts

o partnership profits are the business rewards of partners; partners generally make
withdrawals in anticipation of profits or drawings that considered salary allowance

o noncash drawings should be valued at their market values at the date of the withdrawals

- some make an exception to the rule and instead record at cost, thereby not recording a
gain/loss on these drawings

o withdrawal of regular amounts are called drawings, drawing allowances, or salary

allowances and these are usually charged to the partner’s drawing accounts; these drawings
may be compared with the drawings allowed in the partnership agreement in order to establish
an accounting control over excessive drawings

o withdrawals are disinvestments of essentially the same nature as large and irregular
withdrawals

o drawings accounts should be closed to the capital accounts at the end of each accounting
period

o there are two classes of withdrawals:

a. capital withdrawal or permanent withdrawal- directly affect the capital account

b. personal withdrawal or temporary withdrawal- initially recorded in a drawing

account; often drawings from share of profits which will eventually be closed to capital
accounts
 C. Loan Accounts

o a partner may receive cash from the partnership with the intention of repaying the amount;
these loans are debited to the Loans Receivable from Partners – the amount bears interest
and the interest income is recorded in the Income Statement

o a partner may make a cash payment to the partnership that is considered a loan rather
than an increase in the partner’s capital account balance; these loans are credited to the
Loans Payable to Partners and are normally accompanied by the issuance of a
promissory note – the amount may bear interest and the interest paid is recorded as an
operating expense

o these accounts are related-party transactions for which separate footnote disclosure are
required and must be reported as a separate balance sheet item

• A partner’s capital interest is a claim against the net assets of the partnership as shown
by the balance in the partner’s capital account

• An interest in profit and loss determines how the partner’s capital interest will
increase or decrease as a result of subsequent operations

Accounting for Partnership Formation

A. Cash Investments
o Recorded at fair value/face value which is the amount payable on demand or to be
collected at the balance sheet date

o Cash in foreign currency is valued at the current exchange rate

o Cash in bank under receivership is shown at its estimated recoverable amount

B. Noncash Investment

o Recorded at the agreed value which is normally the fair value of the property at the
time of investment
o Fair value is usually determined by the agreement of all partners, however in the
case of a conflict between agreed value and fair value, agreed value prevails.

o Fair value is the current market price agreed by the partners in the transaction.

o For industry/services, a memorandum entry is essential if it were no value agreed

upon, otherwise a journal entry should be required.
o Liabilities assumed by the partnership should be valued at the present value (fair
value) of the remaining cash flows.
o Individual partners must agree to the percentage of equity that each will have in the
net assets of the partnership. Generally, the capital balance is determined by the
proportionate share of each partner’s capital contribution.

A partnership may be formed in numerous ways, to wit:

a. For the first time

 b. Individual versus individual (two or more persons)

c. Conversion of sole proprietorship to a partnership

i. individual versus sole proprietor

ii. sole proprietor versus sole proprietor

d. Conversion of an old partnership to a new partnership

i. partnership versus sole proprietor

ii. partnership versus partnership

e. Admission of new partners

• To record investments, we may use the Bonus Approach or the Revaluation (Goodwill)
Approach.

o In the Bonus Approach, partners do not consider the intangible assets (goodwill),
they only label it as a

bonus to the partner with lesser capital investment.

o In the Goodwill Approach, the difference between the partner’s investments is

considered the goodwill.

o In accordance with GAAP, the Bonus Approach is used. Unless there is a

specified agreement to use otherwise.

o Under the Goodwill Approach, there is a difference Total Agreed Capital (TAC)
and Total Contributed Capital (TCC). Under the Bonus Approach, both are the
same.

▪ TCC- actual contribution

▪ TAC- how much should the contribution be based on agreement among

partners

o When finding the TAC for the Bonus Method, use the higher contribution.

• When a problem is silent as to whose books will be retained, the assumption is that
a new set of books will be created.
• In preparing the new set of books, equipment is recorded net of depreciation.
However, allowance for doubtful accounts is carried forward. Receivables are recorded at
their gross amount.

• A partnership is not a taxable entity