ACCOUNTING FOR PARTNERSHIPS

3 Dissolution – Changes in Ownership

DEFINITION

The dissolution of a partnership is the change in the relation of the partners caused by any partner ceasing to be
associated in the carrying on as distinguished from the winding up of the business of the partnership (Civil Code
of the Philippines, Article 1828)

On dissolution, the partnership is not terminated, but continues until the winding up of partnership affairs is
completed (Article 1829), Winding up is the process of settling the business or partnership affairs after
dissolution. Termination is that point in time when all partnership affairs are wound up or completed, and is the
end of the partnership life.

Limited life is one of the characteristics of a partnership. Any change in the membership of this form of
business organization will result to dissolution. Dissolution of the partnership does not necessarily imply that
business operations will come to an end. Most changes in the ownership of a partnership are accomplished
without interruption of its normal operations,

Dissolution should be distinguished from liquidation of a partnership. A partnership is said to be liquidated

when the business is terminated; a partnership may be dissolved without being terminated but liquidation is
always preceded by dissolution.

When partnership dissolution occurs, a new accounting entity is formed. The old partnership should first adjust
its books so that all accounts are properly stated at the date of dissolution.

Illustration. When the large international accounting firm, Sycip Gorres Velayo & Co., retires and admits
partners during the year, the former partnership is dissolved and a new partnership begins with little outward
evidence of any change. In fact, the new partnership may retain the dissolved partnership’s name. From the
legal viewpoint, a partnership is dissolved by admission or by retirement of a partner. However, accountants are
more concerned with the substance of an event rather than with its legal form. Therefore, the accountants must
evaluate all the circumstances of the Individual case to determine how a change in partners should be recorded.

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CAUSES OF DISSOLUTION
Partnership dissolution due to changes in ownership occurs for varying reasons and the following are the more
prevalent:
1. Admission of a partner
2. Withdrawal or retirement of a partner
3. Death of a partner
4. Incorporation of the partnership

ADMISSION OF A PARTNER

A new partner can only be admitted into a partnership with the consent of all the continuing partners. This is
based on the principle of delectus personae: No one becomes a member of the partnership without the consent
of all the members. This is because a partnership is based on mutual trust and confidence of the partners.

By admission of a new partner, the old partnership has been dissolved and it is important that a new agreement
be formulated to govern the continuing business operations. A person may become a partner in an existing
partnership by either of the following

1. Purchase of an interest from one or more of the existing partners.

2. Investment of assets in the partnership by the new partner.

The foregoing situations are similar in the sense that the old partnership is legally dissolved, the capital, and
profit and loss ratio will be based on a new partnership agreement. But these are dissimilar in the sense that the
partnership receives no new resources when a third party purchases an interest directly from existing partners,
but it does receive new resources when a third party becomes a partner by investing in the partnership

Liability of Incoming Partner for Existing Obligations

A person admitted as a partner into an existing partnership is liable for all the obligations of the partnership
incurred before his admission as though he had been a partner when such obligations were incurred. Such
liability is limited to his capital contribution, unless otherwise agreed.

Illustration. Milavel Nazario, Martin Penaco and Ricardo Pangan formed NPP, a general professional
partnership, with a capital of P50,000 each on Feb. 14, 2013. On Apr. 8, the partnership incurred an obligation
of P200,000 to Teresita Buenaflor which will be payable on Dec. 16. On June 13, Bienvenida Alvaro was
admitted into the partnership. She contributed P20,000.

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Even if the obligation was incurred before Bienvenida Alvaro’s admission into the partnership, she is still liable
to Teresita Buenaflor but only to the extent of her contribution. Total partnership capital upon admission is
₱170,000 leaving a balance of ₱30,000 (deficit) which will be shared by the old partners equally.

PURCHASE OF AN INTEREST FROM EXISTING PARTNERS

With the consent of all continuing partners, a person may be admitted into an existing partnership by purchasing
an interest directly from one or more of the existing partners. Payment is made personally to the partner from
whom the interest is obtained resulting to mere transfers among capital accounts.

This type of admission will only result to a debit to the capital account of the selling partner for the interest sold
and a credit to the capital account of the buying partner for the interest purchased. The amount debited and
credited is not affected by the actual price for the equity interest. In this type of admission, the total assets, total
labilities and total partners’ equity of the partnership are not affected upon admission.

Illustration. Elizabeth Salvador and Challoner Matero are partners with capital balances of P400,000 and
P200,000, respectively. They share profits in the ratio of 3:1. Their business has been very successful. All
indications show that it will continue to be.

Case 1. Payment to old partners is equal to interest purchased. Partners Elizabeth Salvador and Challoner
Matero received an offer from Janet Matuguinas to purchase directly one-fourth of each of their interest in the
partnership for P150,000. The partners agreed to admit Janet Matuguinas into the firm.

One-fourth of each partner’s capital was transferred to the new partner. The partnership did not receive the cash
paid because the transaction is between Matuguinas and partners Salvador and Matero personally, not between
Matuguinas and the partnership.

Case 2. Payment to old partners is less than the interest purchased. Assume that Janet Matuguinas directly
purchased one-third of each partner’s interest in the Business. Matuguinas paid ₱160,000 for one-third of each
partner’s capital
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The new partner was credited for P200,000 interest in the new partnership. The equity is transferred to
Matuguinas at its book value to the old partners of P200,000. The negotiated price of P150,000 does not affect
the entry because the exchange is between Matuguinas and the old partners and does not involve partnership
assets.

Case 3. Payment to old partners is more than the interest purchased. Partners Elizabeth Salvador and
Challoner Matero received an offer from Janet Matuguinas to purchase directly 30% of each of their interest in
the partnership for P200,000. The partners agreed to admit Janet Matuguinas as a member of the firm.

Thirty percent of each partner's capital was transferred to the new partner. Just like in the other preceding cases,
the partnership did not receive the cash paid because the transaction is between Matuguinas and partners
Salvador and Matero personally, not between Matuguinas and the partnership.

INVESTMENT OF ASSETS IN A PARTNERSHIP

A person may be admitted into a partnership by investing cash or other assets in the business. The assets are
invested into the partnership and not given to the individual partners. The investment will increase the total
assets and the total partners equity

Definition of Terms
Total Contributed Capital. It is the sum of the capital balances of the old partners and the actual investment of
the new partner.
Total Agreed Capital. It is the total capital of the partnership after considering the capital credits given to each
of the partners. Under the bonus method, total agreed
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Capital is equal to the total contributed capital though the capital credits to each partner may be equal to, greater
than or less than his capital contributions.
Bonus. It is the amount of capital or equity transferred by one partner to another partner.
Capital Credit. It is the equity of a partner in the new partnership and is obtained by multiplying the total
agreed capital by the applicable percentage interest of the partner.

Bonus to Old Partners

A partnership may be exceptionally attractive because of superior earnings record such that the old partners may
demand a premium from a new partner. This premium increases the old partners capital interest. This premium
is effected either by allocating a portion of the investment of the new partner to the old partners. The capital
accounts of the old partners are credited for the premium according to their profit and loss ratio.

Illustration. Rebecca Miranda and Stephanie Calamba are partners with capital balances of P400,000 and
P200,000, respectively. They share profits in the ratio of 3:1. The partners agreed to admit Theodore Calaguas
as a member of the firm. The foregoing information will be the basis of the following cases.

Case 1. Total agreed capital is stated. Assume that Theodore Calaguas invested P250,000 for a one-fourth
interest in the business. The partners decided not to revalue the assets of the partnership and that the total agreed
capital is PB850,000.

The Investment of Calaguas resulted to a bonus because the total contributed capital of P850,000 is equal to the
total agreed capital. The partnership net assets are increased only by the amount of the new investment. The
capital credit for Calaguas of P212,500 P37,500 less than his actual investment. The difference represented the
bonus allocated to the old partners in their profit and loss ratio. The use of superscripts in all the cases will
facilitate the formulation of the entries.

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Bonus to New Partner
A new partner may be admitted into the partnership because of his vast financial resources, extensive business
network, distinctive reputation, unique management and/or technical skills. The old partners may be willing to
give a premium for all of these exceptional qualifications by allowing a capital credit greater than the
prospective partner’s investment just to ensure his association with the partnership. This premium will be
treated as a bonus from the equities of the old partners and credited to the new partner.

Case 1. Total agreed capital is stated. Assume that Theodore Calaguas invested P240,000 for a one-third
interest in the business. The total agreed capital is P840,000. The investment of Calaguas resulted to a bonus as
shown by the following table:

The capital credit for Calaguas of P280,000 is P40,000 more than his actual investment. This difference
represented a bonus to the new partner because the total contributed capital is equal to the total agreed capital,
and the capital credit to the new partner is more than his actual investment. The equities of the old partners are
decreased by P40,000 in their profit and loss ratio.

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Sale of Interest to a Partner or an Outsider
When a partner’s interest is sold to another partner or an outsider, the withdrawing partner is paid from the
personal assets of the buyer. Accounting for this sale is similar to admission by purchase of interest. The total
assets of the partnership are not affected by the consideration involved. The required entry will only be a debit
to the seller’s capital account for his capital balance and a credit to the buyer’s capital account for the same
amount.

There are times when a partner withdraws in the middle of the accounting period; in such a case, the books of
the partnership should be updated to determine the retiring partner’s capital balance. Profits or losses should be
measured from the last closing of books to the date of withdrawal and distributed according to their profit or
loss sharing agreement.

Sale of Interest to the Partnership

When a withdrawing partner sells his interest to the partnership, the partner is paid from the assets of the
partnership. He may receive an amount equal to, greater than or less than the balance of his capital account. The
effect of withdrawal is to reduce the assets and the owners’ equity of the partnership.

The accounting issues to be encountered here will be similar to admission by investment of assets but in a
reverse manner. Instead of a new partner joining the partnership by investing assets into the partnership, an old
partner is now leaving the partnership with the business distributing assets to the withdrawing partner. Note that
the withdrawing partner may receive his share of the business in partnership assets other than cash.

Illustration. Suppose that Teofila Albay is retiring in midyear from the partnership of Selisana, Dela Cruz and
Albay because of family relocation. Physical distance will prevent her from coping with the daily rigors of their
fashion and beauty consulting business. After the books have been adjusted for the semi-annual profits but
before revaluation, their capital balances are as follows:

Jessica Selisana, Capital P540,000

Daisy Dela Cruz, Capital 430.000
Teofila Albay, Capita. 210,000

An independent appraiser revalued their cosmetics inventory to P380,000 (a decrease of P60,000) and their land
to P1,010,000 (an increase of P460,000). The profit and loss ratio of the partners is 1:2:1.

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Case 2. Withdrawal at more than book value. Assume that Teofila Albay demanded a P400,000 settlement
for her interest because she firmly believed that she has contributed so much to the success of the business. The
remaining partners agreed for old time’s sake. If the current fair value of the partnership’s net assets exceeded
book value, the settlement price to the withdrawing partner will be greater than his capital account balance. The
excess payment is treated either as a bonus to the retiring partner from the continuing partners.

The entry reflected the fact that Selisana and Dela Cruz granted a P90,000 bonus to Albay that was charged to
their capital accounts in their profit and loss ratios.

Case 3. Withdrawal at less than book value. Assume that Teofila Albay is very eager to retire and is willing
to accept settlement at P280,000. When Albay, the retiring partner, received as settlement an amount less than
her capital balance, in effect, the partner is giving a part of her equity interest to the continuing partners as
bonus. The amount of the bonus is credited to the capital accounts of the continuing partners in their profit and
loss ratio.

Payment to a withdrawing partner at less than book value may also imply that the partnership assets are
overvalued. In this case, the overvalued assets should be Identified and reduced to their fair values.

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