ADVANCE

ACCOUNTING
PRINCIPLES AND PROCEDURAL APPLICATIONS
PARTNERSHIPS:
BASIC
CONSIDERATIONS
AND FORMATION
CHAPTER 1
 DEFINITION OF A PARTNERSHIP
PARTNERSHIP are popular form of business because they are easy to form and because
they allow several individuals to combine their talents and skills in a particular business
ventures.
PARTNERSHIP provide a means of obtaining more capital than a single individual can
obtain and allow the sharing of risks for rapidly growing businesses.
The PARTNERSHIP LAW is the general governing authority for partnerships. 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 ore 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 the 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. However, the partnership
must attempt to make profit; therefore, non-profit organizations may not be
partnerships.
 CHARACTERISTICS OF A
PARTNERSHIP
Before taking up the accounting problems encountered in partnerships, it is helpful to know the
important characteristics of the partnership form of organization.
o 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.
o Ease of Formation. The formation of a partnership does not require as many formalities as
corporation. The partnership may be created by oral or written agreement between two or more
persons, or merely bi inferences from the implication of their conduct.
o Co-Ownership of Partnership Property and Profits. All assets are invested in the partnership
become the property of the partnership. The right of each partner to possess partnership property
for partnership purposes is equal to the right of each of the other partners. Each partners has a
proprietary interest in the partnership. This interest refers to each partner’s share in the earnings
and in the capital.
o 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 death, withdrawal, bankruptcy or incapacity of a
partner. No one can be forced against his will to continue as a partner regardless of the
agreed terms of operations. Other factors which may bring a partnership to an end are
the expiration of the period specified in the partnership contract and the admission of a
new partner.
o 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.
o Unlimited Liability. Each partner may be held personally liable for all the debts of the
partnership. All of his business and personal properties may be used for the settlement
of partnership liabilities. There is, however, a special type of partnership, called limited
partnership. Wherein certain partners are allowed to limit their personal liabilities to the
extent of their capital contributions only.
 ENTITY VERSUS
PROPRIETORSHIP THEORIES
The proprietorship theory views the assets of a business as belonging to the proprietor, the liabilities as
debts of the proprietor, and the income of the business as an increase in the proprietor’s net worth
(capital). In practice, however, proprietorship assets and liabilities are treated separately from the personal
assets and liabilities of the proprietor. Thus, in practice, proprietorship are treated as separate entities,
even though, in theory, they are not.

On the other hand, small partnerships usually viewed as a combination of two or more proprietorships,
and the “proprietorship” theory would be the pertinent one for firms of this size. The death of one partner
would usually cause a dissolution especially if there are only two partners.

Despite the many similarities between partnership and proprietorships, a partnership are generally viewed
as entities separate and apart from the individual partners. Assets are viewed as belonging to the
partnership and not to the individual partners. Income earned by the partnership is usually viewed as
income to the “entity” with each partner entitled to a distributive share of the income.
 PARTNERSHIP AGREEMENT
The formulation of a partnership agreement must be done at the inception of organization of the partnership. 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. among 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 contributions
in excess of agreed amounts, and the penalties for failure to contribute and maintain the agreed amount of capital;
4. The authority, the rights and duties of each partner;
5. The accounting period to be used, the nature of accounting record, 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 partners’ salary and drawing accounts including
the penalties, if any, for excessive withdrawals; and
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 partners death. Especially important 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 partners’ 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
ACCOUNT
In partnership, although it is possible to operate with only one equity for each
partner, it is desirable that the following partner’s account be maintained;

1. Capital accounts
2. Drawing or personal accounts
3. Account for loans to or form partners
Capital and drawing accounts.
The original investments of each partner is recorded by debiting the fair value of the assets
invested, crediting the liabilities assumed by the firm, and crediting the partner’s capital
account for the net assets contributed. Subsequent to the original investments, transactions
between the partnership and the partners will result to changes in the respective partner’s
ownership interest. These changes are summarized in the respective partner’s capital and
drawing accounts.

Normally, increases or decreases in capital that are interpreted as permanent capital changes
are recorded directly in the capital account. Withdrawals which are considered equivalent to
salaries, made by the partner in anticipation of profits, and other increases or decreases of
relatively minor amounts are recorded in the drawing account. Also, during this period, the
profit or loss as shown by the Income Summary account is distributed in accordance with the
profit and loss sharing agreement. The share of each partner in the profit or loss is recorded in
their respective capital account. Individual partner’s capital and drawing balances are
combined to reporting each partner’s interest in the statement of financial position.
The transactions that are usually debited and credited to partner’s capital and drqawing accounts may be
summarized as follows:

The capital account is credited for:

a. Original investment
b. Additional investment.
c. Partner’s share in the profits (sometimes this is closed to the drawing account.)
The capital account is debited for:
d. Permanent withdrawal of capital
e. Debit balance of the drawing account at the end of the period.
f. Partner’s share in the losses (sometimes this is closed to the drawing account).
The drawing account is credited for:
g. Partnership obligations assumed or paid by the partner.
h. Personal funds or claims of partner collected and retained by the partnership.
i. Periodic partner’s salaries depending on the accounting and disbursement procedures agreed upon.
The drawing account is debited for:
j. Withdrawal of assets by the partners in anticipation of net income.
k. Partner’s personal indebtedness paid or assumed by the partnership.
l. Funds or claims of partnership collected and retained by the partner.
Loans to and from partners.
A withdrawal by a partner of a substantial amount with the
assumption of its repayment to the firm may be debited to a
Receivable from partner account rather that to the partner’s drawing
account. On the other hand, an advance to the partnership by a
partner with the assumption of its ultimate repayment by the
partnership is viewed as a loan rather than as an increase in the
capital account. This type of transaction is credited to the Loans
Payable to partners account or notes Payable if the loan is evidenced
by a note duly signed in the name of the partnership.
ACCOUNTING FOR THE FORMATION OF A
PARTNERSHIP
The formation of a partnership presents relatively few difficult accounting
problems. 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 of 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 his business.
b. Two ore more sole proprietors form a partnership.
3. Admission of a new partner ( this is discussed in chapter 3).
PARTNERSHIP FORMATION FOR THE
FIRST TIME – INITIAL INVESTMENT
Cash investments

Initial cash investments in a partnership are recorded in the capital accounts maintained for
each partner. For example, A bad Besa each invests ₱100,000 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.
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.
Bonus or Goodwill on Initial Investments
Valuation problem arises when partners agree on capital interests that are not equal to
their net assets invested. Under the bonus method no assets is recorded in the
partnership books.
When the Goodwill method is used, the equalization of capital interests is
accomplished by recording goodwill with the corresponding increase in the capital
account. The Goodwill method is based on the assumption that an implied value can be
estimated mathematically and recorded for any intangible contribution by a partner.
Comparison of Methods.
The bonus method allocates the invested capital according to the percentages designated
by partners, whereas goodwill method capitalizes the implied value of intangible
contribution.

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.
Sole Proprietorship’s Books are Retained for the Partnerships.
If the books are to be retained, the following accounting procedures are used to
record the formation of the partnership:
1. Adjust the asset and liabilities to their fair market values as agreed by the
partners. Adjustments are to be made to his capital account.
2. Record the investments.

Two Proprietors Form a Partnership

There should be an agreement be an agreement on the determination 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.