CHAPTER 1

Partnerships: Basic
Considerations
and Formation
Prepared By:
Christopher C. Lim
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 profits among
themselves
 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. Any “juridical person” is not allowed to be a
partner because partnership’s one important characteristic is
mutual agency which will be discussed later.
 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.
 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 a profit; therefore, non-
profit organizations may not be partnerships.
 Separate Legal Personality. Article 1768 of the
Partnership Law States 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.

 Ease of Formation. The formation of the 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.
 Co-ownership of Partnership, Property and Profits. All
assets 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 partner has
proprietary interest in the partnership. This interest
refers to each partner’s share in the earnings in the
capital.
 Limited Life. Many factors may bring a partnership to an
end such as:
Change in the agreement of the partners
Death, withdrawal, bankruptcy or incapacity of a
partner
Expiration of the period specified in the partnership
contract
Admission of the new partner
 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.

 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.
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.
Small partnerships are 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 similarities between the partnerships and

proprietorships (i.e., unlimited liability, dissolution upon
death), partnerships 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.
 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. The partnership
agreement may be oral, implied or written. However, it’s best that it be
organized on the basis of written contract.

Observations of these details will help minimize, if not eliminate, the

confusion and disputes that may arise between or among the partners.
Among the more significant points that must be covered by the partnership
agreement are:
Names of the partners, and the name and nature of the partnership:
Date on which the partnership contract takes effect and the duration of the
contract:
Capital to be invested by each partner, procedure for valuing noncash
contributions, 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:
Authority, rights and duties of each partner:
Accounting period to be used, nature of accounting records,
preparation of financial statements, and auditing of partnership books.
Method of sharing profits and losses including the frequency of
income measurement and distribution to partners.
Drawing or salaries to be allowed to each partner ad the disposition of
partner’s salary and drawing accounts including the penalties, if any,
for excessive withdrawals; and
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 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 partner’s retirement.
 Partnership agreements are usually with the aid of or in
consultation with lawyers & certified public accountants.
Some of the areas where the partners may seek the
advice of an accountant are as follows:

 Determination of the current fair values to be assigned to the

noncash assets initially invested to the partnership
 Ascertainment of the individual partner’s initial interest in the
partnership capital
 Formulation of the plan for sharing in the profits or losses
 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 withdrawals are to be closed to the
capital account at the end of the accounting period, thereby,
increasing or decreasing the total capital.
 The formation of the 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:

 Formation of a partnership for the first time

 Conversion of a sole proprietorship to a partnership

 A sole proprietor allows another individual, who has no business of his
own to join his business
 Two or more sole proprietors form a partnership

 Admission of a new partner

Cash Investments
Initial cash investments in a partnership are recorded in the capital
accounts maintained for each partner. For example:
Han and Tan each invests P100,000 cash in a new partnership.
The entry to record the investments would be:
Cash 200,000
Han, capital 100,000
Tan, capital 100,000
To record the investments of Han and Tan.
 Noncash Investments

Noncash property is recorded at the current fair value of the property at the
time of investment. Theoretically, independent appraisals should be made to
determine the fair value. Despite the theoretical soundness of the independent
appraisal procedure, the fair value of noncash asset is determined by
agreement of the partners. The amounts involved should be specified in the
written partnership agreement. To illustrate:

Monzon and Palma form a partnership for the first time. Their investments are as
follows:
Monzon Palma
(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
Monzon, capital 70,000
To record initial investment of
Monzon.

Merchandise inventory 20,000

Computer equipment 30,000
Palma, capital 50,000
To record initial investments of
Palma at their fair values.

Recording partner’s 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.
Under this type of formation:
Assets and liabilities of the sole proprietorship are
transferred to the partnership
Normally, partners agree on the revaluation of some of the
assets before the transfer
Journal entries to record this type of formation will depend
on whether:
 Books of the sole proprietorship are to be used for the
newly formed partnership
 New books are to be opened
 To illustrate, assume that Blake has been operating a retail
store for years. Blake Company’s balance sheet on June 1,
2006 is as follows:

Blake Company
Balance Sheet
June 1, 2006

Assets Liability and Capital

Cash P30,000 Accounts Payable P 50,000
Accounts Receivable 20,000 Blake Capital 150,000
Merchandise Inventory 70,000
Furniture and Fixtures 100,000
Accumulated Depreciation (20,000) 80,000
Total assets P200,000 Total Liability and Capital P200,000
 On June 1, 2006, Blake and Rupuz agreed to form a
partnership. Rupuz is to invest P200,000 cash. Blake is to
contribute the net assets of his business after the agreed
valuation as follows:
P5,000 is to be regarded as bad debts
Fair market value of merchandise inventory is P100,000
Additional depreciation of furniture and fixtures is P10,000

SOLE PROPRIETORSHIP’S BOOKS ARE RETAINED FOR THE

PARTNERSHIP
Adjust the assets of sole proprietorship to their current fair
values as agreed by the partners. Adjustments are to be
made to the proprietor’s capital.

Record the investment of the new partner.

 The journal entries are:

Merchandise Inventory 30,000

Allowance for Bad Debts 5,000
Accumulated Depreciation-Furniture & Fixtures 10,000
Blake, Capital 15,000
To record adjustments of assets to
restate Blake’s capital.

Cash 200,000
Rupuz, capital 200,000
To record cash investment of Rupuz.
 After the formation, the balance sheet of the newly formed
partnership is:

Blake and Rupuz Partnership

Balance Sheet
June 1, 2006

Assets Liability and Capital

Cash P230,000 Accounts Payable P 50,000
Accounts Receivable 20,000 Blake Capital 165,000
Allowance for Bad Debts (5,000) Rupuz Capital 200,000
Merchandise Inventory 100,000
Furniture and Fixtures 70,000
Total Assets P415,000 Total Liability and Capital P415,000
 NEW BOOKS ARE OPENED FOR THE PARTNERSHIP
The following accounting procedures may be used to record
the formation of the partnership if new books are to be
used:
Books of sole proprietorship
Adjust the assets of sole proprietorship according to the
agreement. Adjustments are made to sole proprietor’s
capital account.
Close the books.

New books of the partnership

Record the investments of sole proprietor, his assets and
liabilities.
Record the cash investments of the new partner.
Using the given procedures, the journal entries to record the
formation are: (still assume the case of Blake and Rupuz)

Books of Blake

Merchandise Inventory 30,000

Allowance for Bad Debts 5,000
Accumulated Depreciation- Furniture & Fixtures 10,000
Blake, Capital 15,000
To record adjustments of assets.
Accounts Payable 50,000
Allowance for Bad Debts 5,000
Accumulated Depreciation- Furniture and Fixtures 30,000
Blake, Capital 165,000
Cash 30,000
Accounts Receivable 20,000
Merchandise Inventory 100,000
Furniture and Fixtures 100,000
To close the books.
 New Books of the Partnership

Cash 30,000
Accounts Receivable 20,000
Merchandise Inventory 100,000
Furniture and Fixtures 70,000
Accounts Payable 50,000
Allowance for Bad Debts 5,000
Blake, Capital 165,000
To record investments of Blake.

Cash 200,000
Rupuz, Capital 200,000
To record investment of Rupuz.
Like the accounting procedure described in the preceding section,
there should be agreement on the determination of the partners’
interest in the new partnership.
There should also be an agreement on the values of the assets to be
assigned and liabilities to be assumed by the partnership.
Journal entries to record this type of formation will depend on
whether:
Books of one of the sole proprietorships are
to be used for the newly formed partnership
New set books are to be opened
 To illustrate, assume that on June 30, 2006, Evangelista and Tamio,
both sole proprietors, decide to consolidate their business to form a
partnership. Their balance sheets on this date are as follows:

Evangelista Company
Balance Sheet
June 30, 2006
Assets
Cash P 5,000
Accounts Receivable 10,000
Merchandise Inventory 8,000
Furniture and Fixtures 6,000
Total Assets P29,000

Liabilities and Capital

Accounts Payable P 3,000
Evangelista Capital 26,000
Total Liabilities and Capital P29,000
 Tamio Company
Balance Sheet
June 30. 2006

Assets
Cash P 4,000
Accounts Receivable 8,000
Merchandise Inventory 10,000
Furniture and Fixtures 9,000
Total Assets P31,000

Liabilities and Capital

Accounts Payable P 6,000
Tamio, Capital 25,000
Total Liabilities and Capital P31,000
 The Conditions agreed upon by the partners
for purposes of determining their interests
in the partnership are presented below:

10% of accounts receivable is to be set up as

uncollectible in each book
Merchandise inventory of Tamio is to be increased by
P1,000
The furniture and fixtures of Evangelista and Tamio
are to depreciated by P600 and P900 respectively
Books of Tamio are Used as the Partnership Books
The accounting procedures to record the formation the
partnership are:
 Books of Evangelista
1. Adjust the accounts of Evangelista as agreed.
Adjustments are made to his capital account.
2. Close the books.
 Books of Tamio
1. Adjust the accounts of Tamio as agreed. Adjustments
are made to his capital account.
2. Record the investment of Evangelista, his adjusted
assets and liabilities.
 The journal entries to record the formation of the
partnership using the given accounting procedures
are:

Books of Evangelista
Evangelista, Capital 1,600
Allowance for Bad Debts 1,000
Accu. Depreciation-Furniture & Fixtures 600
To record adjustments of assets.

Accounts Payable 3,000

Allowance for Bad Debts 1,000
Accu. Depreciation-Furniture & Fixtures 600
Evangelista, Capital 24,400
Cash 5,000
Accounts Receivable 10,000
Merchandise Inventory 8,000
Furniture and Fixtures 6,000
To close the books.
 The journal entries to record the formation of the
partnership using the given accounting procedures
are:

Books of Tamio ( Now the Books of the Partnership )

Merchandise Inventory 1,000
Tamio, Capital 700
Allowance for Bad Debts 800
Accu. Depreciation- Furniture and Fixtures 900
To adjust assets of Tamio.

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
Evangelista, Capital 24,400
To record the investments of Evangelista.
 New Partnership Books will be Used
The following accounting procedures will
be used to record the formation of the
partnership.
Books of Evangelista and Tamio
1. Adjust the accounts of Evangelista and Tamio according to
their agreement. Adjustments are to be made to their capital
accounts.
2. Close the books.

New Book of the Partnership

3. Record the investments of Evangelista, his adjusted assets
and liabilities.
4. Record the investments of Tamio, his adjusted assets and
liabilities.
 The journal entries to record the formation of
the partnership using the given accounting
procedures are:
Books of Evangelista
Evangelista, Capital 1,600
Allowance for Bad Debts 1,000
Accu. Depreciation-Furniture & Fixtures 600
To record adjustments of assets.

Accounts Payable 3,000

Allowance for Bad Debts 1,000
Accu. Depreciation-Furniture & Fixtures 600
Evangelista, 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 Tamio

Merchandise Inventory 1,000

Tamio capital 700
Allowance for bad debts 800
Accumulated depreciation-Furniture and fixtures 900
To record adjustments of assets

Accounts payable 6,000

Allowance for bad debts 800
Accumulated Depreciation-Furniture and fixtures 900
Tamio 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
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
Tamio capital 24,400
To record the investment of Evangelista.

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
Tamio capital 24,300
To record the investment of Tamio.
 The balance sheet of the partnership after the formation
is presented as follows:
Evangelista and Tamio Partnership
Balance Sheet
June 30, 2005
Assets
Cash P 9,000
Accounts receivable P 18,000
Less: Allowance for bad debts 1,800 16,200
Merchandise inventory 19,000
Furniture and fixtures 13,500
Total assets P 57,700

Liabilities and Capital

Accounts payable P 9,000
Evangelista capital 24,400
Tamio capital 24,300
Total liabilities and capital P 57,700
 Bonus or Goodwill on Initial Investment
Valuation problem arises when partners agree on capital interests that are not equal
to their net assets invested. For example, in the previous illustration:
Though Monzon invested P70,000 cash and Palma contributed computer
equipment with a fair market value of P50,000, the partners agree that each
of them is to receive equal interest.
To meet this condition. The capital accounts of
each partner should be adjusted using 2
approaches --bonus approach or goodwill
approach.

BONUS APPROACH. No asset is recorded in the partnership books. To equalize capital

balances, capital transfer of P10,000 from Monzon to Palma is made. The only necessary entry is
as follows:
Monzon, capital 10,000
Palma, capital 10,000
To accomplish equal interests of P60,000 by
recording a P10,000 bonus to Palma from Monzon.
 The bonus is computed as follows:
Get the total contribution of the partners
70,000 + 50,000 = 120,000
Multiply it by the agreed interest of partners to get their
agreed capital
Monzon 120,000 * .50 = 60,000
Palma 120,000 * .50 = 60,000
Subtract their agreed capital by their contributed capital
Monzon 60,000 - 50,000 = 10,000
Palma 60,000 - 70,000 = (10,000)

Positive amount is the

bonus received and
negative is the bonus
given.
 GOODWILL APPROACH. The equalization of capital interest
is accomplished by recording goodwill of P20,000 with
corresponding increase in the capital account of Palma.
The entry is:

Goodwill 20,000
Palma, capital 20,000
To establish equal capital interests of
P70,000 by recording goodwill of P20,000.

The goodwill is computed as follows:

Gross up the capital of each partner by dividing their contributed capital by
the agreed interest.
Monzon 70,000 / .50 = 140,000
Palma 50,000/ .50 = 100,000
Choose the higher grossed up amount and multiply it by the partners’
corresponding agreed interest to get their agreed capital.
Monzon 140,000 * .50 = 70,000
Palma 140,000 * .50 = 70,000
 Subtract the agreed capital by the contributed capital of each partner.
Monzon 70,000 – 70,000 = 0
Palma 70,000 – 50,000 = 20,000

If there are three or more

partners,choose the highest
grossed up agreed capital in
computing goodwill.

Bonus and goodwill approach are equally acceptable. A decision to use one
approach over the other will depend on the partners’ agreement.
  Capital accounts
 Drawing or personal accounts
 Account for loans to or from partners

Capital and Drawing Accounts

The original investment 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 the changes in the
respective partner’s ownership interest. These changes are
summarized in the respective partner’s capital and drawing
accounts.
 The transactions that are usually debited and credited
to partner’s capital and drawing accounts may be
summarized as follows:

Capital Account
Debit Credit
Permanent withdrawal of capital Original investment
Debit balance of the drawing Additional investment
account at the end of the period Partner’s share in the profits
Partner’s share in the losses (sometimes this is closed to the
(sometimes this is closed to the drawing account)
drawing account)
 Drawing Account
Debit Credit
Withdrawal of assets by the Partnership obligation assumed
partners in anticipation of net or paid by the partner
income Personal funds or claims of
Partner’s personal indebtedness partner collected or retained by
paid or assumed by the the partnership
partnership Periodic partner’s salaries
Funds or claims of partnership depending on the accounting and
collected or retained by the disbursement procedures agreed
partner upon
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 than 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 or Notes Payable if the loan is evidenced by a note duly
signed in the name of the partnership.
Partnership is an accounting entity separate from each of the
partners.
Assets are invested at their current fair values at the time of
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
partner’s capital accounts and is also the value of the
partnership’s net assets.
The partners may allocate the capital contributions in any manner they
desire.
Fundamental accounting equation (assets - liabilities = capital) is used
often in partnership accounting.
Each partner’s capital interest recorded does not necessarily have to
equal his capital contribution
The accountant must be sure that all the partners agree to the
allocation and must then record it accordingly.