PARTNERSHIPS: BASIC

CONSIDERATIONS &
FORMATION
Chapter 1
Adapted from Guerrero & Peralta (2017)
Advanced Accounting

Sharilyn D. Penales, CPA, MBA

Teacher
 Learning Objectives:

1. Define what is partnership.

2. Identify the characteristics of a partnership.
3. Distinguish Entity versus Proprietorship Theories.
4. Explain what is partnership agreement
5. Know the Partner’s ledger accounts.
6. Account partnership formation.
Definition of Partnership

The Partnership Law is the general governing authority for

partnerships. Accountants advising partnerships must be
familiar with this law because it describes many of the rights
of each partner and of creditors during creation, operation,
and liquidation of the partnership. Article 1767 of the
Partnership Law embodies the definition of partnership. It
states that "by the contract of partnership, two or more
persons bind themselves to contribute money, property or
industry to a common fund with the intention of dividing the
profits among themselves.”
 This definition encompasses three distinct factors:
1. Association of Two or More Persons. The “persons” are
usually individuals. Any natural person who possesses the
right to enter into a contract can become a partner.
2. To Carry On as Co-Owners. A partnership is an aggregation
of partners’ individual rights. This means that all partners are
co-owners of partnership property and are co-owners of the
profits or losses of the partnership.
3. Business for Profit. A partnership may be formed to perform
any legal business, trade or profession, or other service.
Characteristics of a Partnership
1. Separate Legal Personality. Article 1768 of the
Partnership Law states that the partnership has a juridical
personality separate and distinct from that of each of the
partners. A partnership may, therefore, acquire property in its
own name and may enter into contracts.

2. Ease of Formation. The formation of a partnership does

not require as many formalities as a corporation. The
partnership may be created by oral or written agreement
between two or more persons, or merely by inferences from
the implication of their conduct.
Characteristics of a Partnership

3. Co-ownership of Partnership Property and Profits. All

assets invested in the partnership become the property of
the partnership.

4. Limited Life. Any change in the agreement of the

partners terminates the partnership contract. A partnership
may also expire any time when there is a change in the
relationship of the partners due to the death, withdrawal,
bankruptcy or incapacity of a partner.
Characteristics of a Partnership
5. Mutual Agency. Each partner has an equal right to act
for the partnership and to enter into contracts binding upon
it, as long as he acts within the normal scope of business
operations. Each partner is a principal as well as an agent of
the partnership.
6. Unlimited liability. Each partner may be held personally
liable for all the debts of the partnership. However, there is a
special type of partnership, called limited partnership,
wherein certain partners are allowed to limit their personal
liabilites to the extent of their capital contributions only.
Partnership Agreement
The formulation of a partnership agreement must be done at
the inception of organization of the partnership. This
agreement is the framework within which the partners are to
operate or conduct partnership business from formation to
operations then to the eventual dissolution and liquidation of
the partnership. Observations of these details will help
minimize, if not eliminate, the confusion and disputes that
may arise between or among the partners. The partnership
agreement may be oral, implied or written. However, it is
best that the business of the partnership be organized on
the basis of a written contract. It is not possible to cover in
the partnership contract every issue which may later arise.
Partnership Agreement
Among the more significant points that must be covered by
the partnership agreement are:
1. Names of the partners, and the name and nature of the
partnership;
2. The date on which the partnership contract takes effect
and the duration of the contract;
3. The capital to be invested by each partner, the procedure
for valuing noncash contributions, the treatment of any
contribution (whether as capital or as loan) in excess of
agreed amounts, and the penalties for failure to contribute
and maintain the agreed amount of capital);
Partnership Agreement
4. The authority, the rights and duties of each partner;
5. The accounting period to be used, the nature of
accounting records, preparation of financial statements, and
auditing of partnership books.
6. The method of sharing profits and losses including the
frequency of income measurement and distribution to
partners.
7. The drawings or salaries to be allowed to each partner
and the disposition of panner’ s salaiy and drawing accounts
including the penalties, if any, for excessive withdrawals;
Partnership Agreement

8. Provision of the arbitration of disputes and the liquidation

of the partnership at the termination of the agreed time
including those concerning the contingency of a partner’s
death. Especially 1mportant are the rules on the valuation of
assets including goodwill and the method of settlement with
the estate of a deceased partner. Similar provisions should
be made with respect to a partner’s retirement.
Partnership agreements are usually with the aid of or in
consultation with lawyers and certified public accountants.
Some of the areas where the partners may seek the advice
of an accountant are as follows:

1. The determination of the current fair values to be

assigned to the noncash assets initially invested to the
partnership.
2. The ascertainment of the individual partner’s initial
interest in the partnership capital.
3. The formulation of the plan for sharing in the profits or
losses.
4. The determination of the methods to compute the interest of
a withdrawing partner as a result of his retirement or death. A
factor to be considered in cases of withdrawal is the necessity
of revaluing the assets and recognizing intangible asset values
such as goodwill.
5. The determination of the closing procedures to be followed,
that is, whether or not income and withdrawals are to be
closed to the capital account at the end of the accounting
period, thereby, increasing or decreasing the total capital.
Partner's Ledger Accounts
1. Capital accounts
2. Drawing or personal accounts
3. Account for loans to or from partners

The transactions that are usually debited and credited to

partner's capital and drawing accounts may be summarized
as follows:
The capital account is credited for:
a. Original and additional investment
b. Partner's share in the profits
Partner's Ledger Accounts
The capital account is debited for:
a. Permanent withdrawal of capital
b. Debit balance of the drawing account at the end of the period.
c. Partner's share in the losses
The drawing account is credited for:
d. Partnership obligations assumed or paid by the partner.
e. Personal funds or claims of partner collected and retained by the
partnership.
f. Periodic partner's salaries depending on the accounting and
disbursement procedures agreed upon.
Partner's Ledger Accounts
The drawing account is debited for:
a. Withdrawal of assets by the partners in anticipation of net
income.
b. Partner's personal indebtedness paid or assumed by the
partnership.
c. Funds or claims of partnership collected and retained by the
partner.
Accounting for the formation of partnership

Accounting entries to record the formation will depend upon

how the partnership is formed. A partnership may be formed in
several ways, namely:
1. Formation or a partnership for the first time.
2. Conversion of a sole proprietorship to a partnership.
a. A sole proprietor allows another individual, who has no
business of his own to join in his business.
b. Two or more sole proprietors form a partnership.
3. Admission of a new partner(This will be discussed in
chap.3)
 Partnership Formation for the First time - Initial
Investments.
Cash Investments

For example, Abad and Besa each invests P100,000 cash in a

new partnership. The entry to record the investments would
be:
Cash 200,000
Abad, capital 100,000
Besa, capital 100,000
To record the investments of Abad and Besa.
 Partnership Formation for the First time - Initial
Investments.
Noncash Investments

When property other than cash is invested in a partnership,

the noncash property is recorded at the current fair value of
the property at the time of the investment. Theoretically,
independent appraisals should be made to determine the fair
value. Despite the theoretical soundness of the independent
appraisal procedure, the fair value on noncash asset is
determined by agreement of the partners. The amounts
involved should be specified in the written partnership
agreement.
Illustration
Assume that Pedro and Jose form a partnership for the first
time. Their investments are as follows:

Pedro Jose
(Fair Value) (Fair Value) Cash
P70,000 -
Merchandise inventory (cost, P10,000) P20,000
Computer equipment (cost, P50,000) - 30,000
Total P70,000 P50,000
The journal entries to record the investments are as
follows:
Cash 70,000
Pedro, capital 70,000
To record initial investment of Pedro

Merchandise inventory 20,000

Computer equipment 30,000
Jose, capital 50,000

To record initial investments of Jose at their fair values

Recording partners’ noncash investments at their current fair
value ensures that any gains or losses on the subsequent sale
of the property will be equitably distributed in accordance with
the partnership agreement.
Bonus or Goodwill an Initial Investments
Valuation problem arises when partners agree on capital
interests that are not equal to their net assets invested. For
example, in the above illustration, the partners agree that each
partner is to receive equal interest, even though Pedro
invested P70,000 and Jose contributed, P50,000 in identifiable
net assets.
To meet this condition, the capital accounts of Pedro and Jose
should be adjusted using two methods the bonus method or
the goodwill method.
Under the bonus method, there is capital interest transfer. To
equalize capital balances to P60,000, capital transfer of
P10,000 from Pedro to Jose is made. The only entry
necessary is as follows:
Pedro capital 10,000 Jose capital
10,000
To accomplish equal capital interest of 60,000 by recording
10,000 bonus to Jose from Pedro.
When the goodwill method is used, the equalization of capital
interests is accomplished by recording goodwill of P20,000
with a corresponding increase in the capital account of Jose.
The entry is:
Goodwill 20,000
Jose capital 20,000

To establish equal capital interests of P 70,000 by recording

goodwill of P20,000.
The goodwill method is based on the assumption that an
implied value can be estimated mathematically and recorded
for any intangible contribution made by a partner. In the above
illustration, Jose invested P20,000 less cash than Pedro’s
investment but receives an equal amount of capital according
to the partners’ agreement.

In the above entry, Jose received a goodwill attributed to his

business connections.
A decision to use one method over the other will depend on
the partner's agreement. In the absence of any agreement,
the bonus method is preferable over the goodwill method.
 Sole Proprietor and another individual form a
partnership
An individual who has no business of his own may join
another individual who is already operating his own
business. Under this type of formation, both the assets and
liabilities of the sole proprietor are transferred to the newly
formed partnership.Normally, the partners agree on the
revaluation of some of the assets before the transfer. The
journal entries to record this type of formation will depend
on whether the books of the sole proprietorship are to be
used for the newly formed partnership or new books are to
be opened.
Illustration
Jose Company
Assume that Jose has Statement of Financial Position
been operating a retail July 1, 2020

store for a number of Assets

years. A statement of Cash 60,000

Accounts Receivable 50,000
financial position on July 1,
Inventory 70,000
2020 is prepared for Jose Equipment 40,000
Company as follows: Less: Accum. Dep'n. 4,000 36,000
Total Assets 216,000
Liabilities & Equity
Accounts Payable 86,000
Jose capital 130,000
Total liabilities & equity 216,000
Jose needs additional capital to meet the increasing sales
and offers Pedro an interest in the business. Jose and Pedro
agree to form a partnership to be known as JP Partnership;
Jose’s business is audited and its net assets are appraised.
The audit and appraisal shows the following:

1. Allowance for bad debts of P5,000 is to be provided.

2. Inventory is to be recorded at its market value of P80,000.
3. The equipment has a fair value of P35,000
4. P2,000 of accounts payable has not been recorded. ,
Jose and Pedro prepare and sign articles of co-partnership
that include all significant operating policies. On July 1, 2020
Pedro contribute P100,000 cash for a one-third capital
interest. The JP Partnership is to acquire all of Jose’s
business and assume its liabilities.
Sole Proprietorship's Books are retained for the Partnerships.
If the books of Jose are to be retained, the following
accounting procedures are used to record the
formation of the partnership:

1 . Adjust the assets and liabilities of Jose to their fair market

values as agreed by the partners. Adjustments are to be
made to his capital account.
2. Record the investment of Pedro.
Using the above procedures, the journal entries to record the
formation of the partnership are: .
Books of Jose (Now the Partnership Books)
2020
July 1
(1) Inventory 10,000
Accumulated depreciation-Equipment 4, 000
Equipment 5, 000 Allowance for bad
debts 5, 000 Accounts payable
2, 000 Jose, capital 2,000 To adjust
assets and liabilities ofJose.
2) Cash 100,000
Pedro, capital 100,000
To record investment of Pedro.
Illustration
JP Partnership
After the formation, the Statement of Financial Position
statement of financial July 1, 2020

position of the newly Assets

Cash 160,000
formed partnership is: Accounts Receivable 50,000
Less: Allow. for bad debts 5,000 45,000
Inventory 80,000
Equipment 35,000
Total Assets 320,000
Liabilities & Equity
Accounts Payable 88,000
Jose capital 132,000
Pedro capital 100,000
Total liabilities & equity 320,000
New Books are Opened for the Partnership. If new books are
to be used for the partnership, the following accounting
procedures may be used to record the formation of the
partnership:
Books of Jose:
1 . Adjust the assets and liabilities of Jose according to the
agreement. Adjustments are made to his capital account.
2. Close the books.
New Books of the Partnership:
1 . Record the investments of Jose. His assets and liabilities.
2. Record the cash investment of Pedro.
Using the procedures, the journal entries to record the
formation of the partnership are:
Books of Jose (Sole Proprietorship):
2020
July 1
(1) Inventory 10,000
Accumulated depreciation-Equipment 4,000
Equipment 5,000 Allowance for bad
debts 5,000 Accounts payable
2,000 Jose, Capital 2,000
To adjust assets and liabilities ofJose.
(2) Accounts payable 88,000
Allowance for bad debts 5,000
Jose, Capital 132,000
Cash 60,000 Accounts
receivable 50,000 Inventory
80,000 Equipment 35,000

To close all the adjusted balances of the accounts.

New Books of the Partnership
July 1, 2020
(1) Cash 60,000
Accounts receivable 50,000
Inventory 80,000
Equipment 135,000 Accounts payable
88,000 Allowance for bad debts
5,000 Jose, Capital 132,000
To record investments ofJose.
(2) Cash 100,000
Pedro Capital 100, 000
To record cash investment of Pedro.
Two Proprietors Form a Partnership

The accounting procedures described in the preceding

section are also applicable when two or more
proprietorships join together to form a partnership. There
should be an agreement on the detetmination of the
partners’ interest in the new partnership. It is also important
that the partners agree on the values of the assets to be
assigned and liabilities to be assumed by the partnership.
Books of one of the sole proprietorship may be used for the
newly formed partnership or a new set of partnership books
may be used.
Illustration

Assume that on June 30, 2020, Gerry and Henry,

competitors in business, decide to consolidate their
business to form a partnership to be called GH Partnership.

The statement of financial position of Gerry and Henry on

this date are presented below.
Illustration
Gerry Company Henry Company
Statement of Financial Position Statement of Financial Position
June 30, 2020 June 30, 2020
Assets Assets
Cash 5,000 Cash 4,000
Accounts Receivable 10,000 Accounts Receivable 8,000
Merchandise Inventory 8,000 Merchandise Inventory 10,000
Furniture & Fixtures 6,000 Furniture & Fixtures 9,000
Total Assets 29,000 Total Assets 31,000
Liabilities & Equity Liabilities & Equity
Accounts Payable 3,000 Accounts Payable 6,000
Gerry capital 26,000 Henry capital 25,000
Total liabilities & equity 29,000 Total liabilities & equity 31,000
The conditions agreed by the partners for purposes of
determining their interests in the partnership are presented
below:
a. 10% of accounts receivable is to be set up as
uncollectible in each book.
b. Merchandise inventory of Henry is to be increased by
P1,000.
c. The furniture and fixtures of Gerry and Henry are to be
depreciated by P600 and P900 respectively.
Books of Henry are used as the Partnership Books. If the
books of Henry are to be used as the partnership books,
the accounting procedures to record the formation of
the partnership are:

Books ofGerry
1. Adjust the accounts of Gerry as agreed. Adjustments are
made to his capital account.
2. Close the books.
Books of Henry (Now the partnership books)
1. Adjust the accounts of Henry as agreed. Adjustments are
made to his capital account.
2. Record the investment of Gerry, his adjusted assets and
liabilities.

The journal entries to record the formation of the

partnership, using the above accounting procedures are:
Books of Gerry
2020
June 30
(1) Gerry capital 1,600
Allowance for bad debts 1, 000 Accu.
depreciation -furniture and fixtures 600

To record adjustments of assets.

(2) Accounts payable 3,000
Allowance for bad debts 1,000 Accum Depn-
furrniture and fixtures 600
Gerry capital 24,400
Cash 5,000 Accounts receivable
10,000 Merchandise inventory
8,000
Furniture and fixtures 6,000
To close the books.
Books of Henry (Now the books of the partnership)
2020
June 30
(1) Merchandise inventory 1,000
Henry capital 700 Allowance for
bad debts . 800 Accum. Depn -furniture and
fixtures 900 To adjust assets of Henry.
(2) Cash 5,000
Accounts receivable 10,000
Merchandise inventory 8,000
Furniture and fixtures 5,400
Accounts payable 3,000 Allowance
for bad debts 1,000 Gerry capital
24,400

To record investments of Gerry.

New Partnership Books will be used. If new books are to be
opened for the partnership, the following accounting
procedures may be used to record the formation of the
partnership.

Books of Gerry and Henry

1. Adjust the accounts of Gerry and Henry according to their
agreement. Adjustments are to be made to their capital
accounts.
2. Close the books
New Book of the Partnership
1. Record the investment of Gerry, his adjusted assets and
liabilities.
2. Record the investment of Henry, his adjusted assets and
liabilities.

Using the accounting procedures, the journal entries to

record the formation of the partnership under this
assumption are:
Books of Gerry
2020
June 30
(1) Gerry capital 1,600
Allowance for bad debts 1,000 Accum.
Depn -furniture and fixtures 600
To record adjustments of assets.
(2) Accounts payable 3,000
Allowancefor bad debts 1,000
Accum. Depn-furniture & fixtures 600
Gerry capital 24,400
Cash 5,000 Accounts receivable
10,000 Merchandise inventory
8,000 Furnitures and fixtures 6,000
To close the books.
Books of Henry
2020
June 30
(1) Merchandise inventory 1,000
Henry capital 700 Allowance for
bad debts 800 Accum. depn -furn. & fixtures
900

To record adjustments of assets.

(2) Accounts payable 6,000
Allowance for bad debts 800
Accum. depn-fur. & fixtures 900
Henry capital 24,300
Cash 4,000 Accounts receivable
8,000 Merchandise inventory
11,000
Furniture and fixtures 9,000
To close the books.
New Books of the Partnership
2020
June 30
(1) Cash 5,000
Accounts receivable 10,000 Merchandise
inventory 8,000
Furniture and fixtures 5,400
Accounts payable 3,000 Allowancefor
bad debts 1,000 Gerry capital
24,400
To record the investments of Gerry.
(2) Cash 4,000
Accounts receivable 8,000
Merchandise inventory 11,000
Furniture and fixtures 8,100
Accounts payable 6,000 Allowance for
bad debts 800 Henry capital
24,300
To record the investments of Henry.
Take note that the Furniture and Fixtures accounts are
recorded net of the accumulated depreciation.
 GH Partnership
The statement of financial Statement of Financial Position
June 30, 2020
position of the partnership Assets
after the formation is as Cash 9,000
follows: Accounts Receivable 18,000
Less: Allow. for bad debts 1,800 16,200
Msde. Inventory 19,000
Furniture & Fixtures 13,500
Total Assets 57,700
Liabilities & Equity
Accounts Payable 9,000
Gerry capital 24,400
Henry capital 24,300
Total liabilities & equity 57,700
Key Observation from the Illustrations. Note that the
partnership is an accounting entity separate from each of
the partners, and that the assets invested are recorded at
their current fair values at the time of the formation. No
accumulated depreciation is carried forward to the
partnership. All liabilities are recognized and recorded.
The capital of the partnership is the sum of the individual
partners’ capital accounts and is also the value of the
partnership’s net assets. The fundamental accounting
equation (assets less liabilities equals capital) is used often
in partnership accounting.
Each partner’s capital interest recorded does not
necessarily have to equal his capital contribution. The
partners may decide to divide the total capital equally
regardless of the actual contributions. The key point is that
the partners may allocate the capital contributions in any
manner they desire. The accountant must be sure that all
partners agree to the allocation and must then record it
accordingly.
THANK YOU AND GOD BLESS