Chapter 1 Partnership Formation

Intended Learning Outcomes:

1. Differentiated between the accounting for partnerships, sole proprietorships, and corporations.
2. Stated the valuation of contributions of partners.
3. Stated the peculiar accounts used in a partnership and identified the transactions that affect these
accounts.

Introduction
A partnership is an unincorporated association of two or more individuals to carry on, as co-owners, a business, with
the intention of dividing the profits among themselves.

The following distinguish a partnership from other types of entities:

A. A partnership is owned by two or more individuals while a sole proprietorship is owned by only one individual.
B. A partnership is created by agreement between the partners while a corporation or cooperative is created by the
operation of law.
C. A partnership is formed for a business undertaking that is normally of continuing nature while a joint venture may
or may not be formed for an undertaking that is to be continued over several years.

Characteristics of a Partnership
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.

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.

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 a proprietary interest in the partnership. This interest refers to
each partner’s share in the earnings and in the capital.

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. 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.

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 of the
extent of their capital contributions only.

Partners’ Ledger Accounts

The partners’ ledger accounts are:
A. Capital accounts
B. Drawings accounts
C. Receivable from/payable to a partner.
Capital and Drawings accounts
Each partner has his or her own capital and drawings account, e.g., “Juan dela Cruz, Capital” and “Juan dela Cruz,
Drawings.” These accounts are equity accounts and are used to record the following transactions.

Juan dela Cruz, Capital

Dr. Cr.
- Permanent Withdrawals of capital - Initial investment
- Share in losses - Additional investments
- Debit balance of drawings account - Share in profits

The partner’s capital account is a real account and has a normal credit balance.

Juan dela Cruz, Capital

Dr. Cr.
- Temporary withdrawals during the - Recurring reimbursable costs paid by the partner
period
- Temporary funds held to be
Remitted to the partnership

The drawings account is a nominal account that is closed to the related account at the end of the period.
This account is a contra equity account and has a normal debit balance.
The partners’ capital and drawings accounts are similar to the corporate paid in capital, retained earnings,
and dividends accounts.

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 account or Notes Payable if the loan is evidenced by a not
duly signed in the name of the partnership.

Note:
Accounting for partnership formation requires the proper valuation of the partners’ contributions, together with an
agreement among themselves as to the amount by which their capital accounts will be credited for the respective
contributions made.

Contributed assets are recognized at fair values while assumed liabilities are taken up at the present values. If these
values are not available book values may be used, except for goodwill and prepaid ordinary expenses which are
deemed to have zero fair values.

Capital credits must conform with the agreed interest ratio. If not given, the ratio of individual contributions is used
instead. If the interest ratio is the same as the contributions ratio (net investment method), every partner’s
contribution will be credited for the same amount. This also means the bonus method becomes applicable
whenever the agreed interest ratio is not identical with the partners’ contribution ratio. Note that goodwill feature
is not assumed throughout the text, any such intent is replaced by revaluation/adjustment of net assets instead.
BRIEF SUMMARY| PARTNESHIP Non-profit organization
may not be organization
Non-profit partnership
may not be partners
Partnership Association of two or more persons to carry as co-owner’ engaged in
a business for profit

Characteristics
1. Separate legal personality No limit to liability as well as to the exposure
2. Ease of formation of the personal assets.
3. Co-owner of partnership property and profits 1.General Partnership – all
4. Limited Life partners are individually liable.
Each partner is 5. Mutual Agency
a principal as 6. Transfer of ownership 2.Limited Partnership – at least one general
well as agent of 7. Unlimited Liability partner who maintains unlimited liability.
partnership Usually has “LLP” in the name.

TOPIC 1 | Accounting for partnership – Formation

Major Considerations in accounting for the equity of a partnership

1. Formation
2. Partnership, as generally a consensual
Operations contract, is perfected by mere consent
3. Dissolution of the partners.
4.
Liquidation

Formation Accounting for initial investments to the partnership

Agreement In any form - oral or written

Exceptio
ns Partnership is void
if:
In public instrument in any of the ff.: - inventory of the immovable is
1. Immovable property is contributed not made, signed by the
2. Real right is contributed parties, and attached to the
public instrument

3. Capital is P3,000 or more (and must be recorded in the SEC)

Note for No. 3:
The partnership still has juridical personality
even if it fails
In money or to register with the SEC. The partnership and its
property members are still liable to third parties. (Art.
1772 Civil Co
Contributions

Forms
1. Cash - measured at face value
2. Property
3. Services
The partnership agreement or
Measurement of Property/Services contract operates as a law
between the partners as
For inventories, at contracting parties.
cost or net 1. At agreed value:
realizable
value, whichever is
lower, if FMV is ➢ Usually equal to fair market value
not ➢ If not equal to fair market value - agreed value prevails
availabl 2. At fair market value - if no agreed value
e
3. At carrying value - if no fair market value (n/a to services

Review Questions for Brief Summary and Topic1

1. Partnership agreement is an express contract among the partners (the owners of the
business). Such an agreement generally does not include:

A. The rights and duties of the partners.

B. A limitation on a partner’s liability to creditors.
C. The rights and duties of the partners in the event of partnership dissolution.
D. The allocation of income between the partners.

A, C and D – discussed and presented in the partnership agreement

B -correct answer.

2. A partnership records a partner’s investment of noncash assets in the business at:

A. A special value set by the partners.

B. The market value of the assets invested.
C. The partner’s book value of the assets invested.
D. Any of the above, depending upon the partnership agreement.

D -correct answer. First priority in measurement is the partnership’s agreed value.

3. When property other than cash is invested in a partnership, at what amount should the
non cash property be credited to the contributing partner’s capital account?

A. Contributing partner’s original cost.

B. Fair value at the date of recognition.
C. Assessed valuation for property tax purposes.
D. Contributing partner’s tax basis.

B -correct answer. Again, the noncash asset (or service) is valued at the partner’s agreed
valuation. In its absence, the capital contribution introduced in noncash form, is brought into
the partnership at fair value at the date of contribution/recognition.

4. Partner D contributed inventory costing P300 and with a net realizable value of P200 to a
partnership. A payable related to this account costing P50 will be assumed by the partnership.
Capital account to be credited to Partner D is P150.

A.
true
B.
false

A -correct answer. There is no agreed value and fair market value for the inventory. Thus it is
measured at Net Realizable Value (estimated selling price less costs to sell), or cost, whichever is
lower. In this case, NRV is lower: P150 (P200 – P50 payable).

5. On December 1,2020, A and B formed a partnership, with A contributing cash and inventories. A
and B mutually agreed that the inventories of A shall be taken to the partnership at a value of
P50,000. On this date, the selling price of the inventories in the market is P55,000. At December
31, 2020, the inventories remained unsold and their net realizable value is P53,000.
 At what amount shall the capital of partner A be credited for the inventories upon formation?

A. P50,000 C. P53,000
B. P55,000 D. P54,000

6. At what amount shall the inventories be measured at December 31, 2020?

A. P50,000 C. P53,000
B. P55,000 D. P54,000

By virtue of the partnership agreement, the inventories shall be recorded at P50,000, the agreed
value, with a corresponding credit to A’s capital account for the same amount. 5-A. Upon initial
recognition, the P50,000 shall now become the cost of the inventories to the partnership.

The inventories shall be measured at the lower of cost and NRV at December 31, 2020 (PAS
2). The cost of the inventories is the value upon initial recognition by the partnership: P50,000.
Since it is lower than the year-end NRV of P53,000, the inventories are measured at their cost. 6-A

TOPIC 2 | Accounting for partnership – Formation

Illustrative Problem:

N and R formed a partnership with the following contributions:

N R
Cash P 150,000 P 20,000
Accounts Receivable 20,000
Inventories 120,000
Land 120,000
Building 180,000
Total P 290,000 P 320,000

Note Payable P 50,000

N, Capital 240,000
R, Capital P 320,000
Total P 290,000 P 320,000

Additional Information:
✓ Accounts receivable included P10,000 which is deemed worthless.
✓ Inventory has an estimated selling price of P150,000 and estimated cost to sell of
P40,000.
✓ Building is under-depreciated by P35,000.
✓ The building has also unpaid mortgage of P20,000 but this is not assumed by the
partnership.
✓ Note payable is stated at face amount. A proper valuation requires the recognition of
P15,000 discount on note payable.
✓ N and R shall share profits and losses equally.

1. Compute for the adjusted balances of each partner.

 N R Partnership
Cash P 150,000 P 20,000 P 170,000
Accounts Receivable (20,000 – 10,000) 10,000 10,000
Inventories (whichever is lower)
NRV (150,000 – 40,000) 110,000 110,000 110,000
Cost 120,000
Land 120,000 120,000
Building (180,000 – 35,000) 145,000 145,000
Total P 270,000 P 285,000 P 555,000
Notes payable, net (50,000 – 15,000) ( 35,000) ( 35,000)
Adjusted Capital Balances P 235,000 P 285,000 P 520,000

The unpaid mortgage on the building is not included because it is not assumed by the
partnership.

Journal Entry:

Cash P 170,000
Account Receivable 10,000
Inventories 110,000
Land 120,000
Building 145,000
Discount on note payable 15,000
Notes Payable P 50,000
N, Capital 235,000
R, Capital 285,000

2. Which partner should invest additional cash and how much if we assume that the partners’
capital shall be increased accordingly to bring the capital balances proportionately to their profit
and loss?

Let’s use N’s Capital first to determine if R’s capital contribution is sufficient.

N, Capital 235,000
Divide by profit and loss ratio of N 50%
470,000
Multiply by R’s profit and loss ratio 50%
Minimum capital requirement 235,000
R’s Capital 285,000
Deficiency on R’s capital contribution -

R’s contribution is sufficient. None, since the result is an “excess”

Now let’s use R’s Capital to determine if N’s capital contribution is sufficient.

R, Capital 285,000
Divide by profit and loss ratio of R 50%
Total 570,000
Multiply by N’s profit and loss ratio 50%
Minimum capital requirement 285,000
N’s Capital 235,000
Deficiency on N’s capital contribution 50,000

N should provide additional cash of P50,000 to make his contribution proportionate to his
profit or loss ratio.
 3. Using bonus method, how much will be the capital balance of each partners assuming both
have equal interest?

Actual Contributions Bonus Method

N P 235,000
Equal sharing of capital = (520,000/2)
R 285,000
Total P 520,000 = P260,000

Adjusted Balance of N is P260,000 with P25,000 bonus (P260,000 – P235,000). The

bonus given to N is treated as a reduction to the capital credit of R.
Journal Entry:
Bonus method requires transfer of capital

Cash P 170,000
Account Receivable 10,000
Inventories 110,000
Land 120,000
Building 145,000
Discount on note payable 15,000
Notes Payable P 50,000
N, Capital (235,000 + 25,000) 260,000
R, Capital (285,000 – 25,000) 260,000

In “Bonus Method”, a partnership agreement may allow a certain party who is bringing in expertise
or special skill to the partner to have a capital credit greater than the fair value of his contributions.

4. Using variations to the bonus method, how much is the cash settlement between partners and
which partner shall receive cash payment from the other partner?

N R Partnership
Adjusted Capital Balances P 235,000 P 285,000 P 520,000
Equal interest (520,000/2) 260,000 260,000 520,000
Cash receipts (payment) ( 25,000) 25,000 -
R will received P25,000 from N
Journal Entry:
Cash P 170,000
Account Receivable 10,000 Note that there is still
Inventories 110,000 transfer of capital, but
Land 120,000 the partners will have
Building 145,000 settlement between
Discount on note payable 15,000 themselves.
Notes Payable P 50,000
N, Capital (235,000 + 25,000) 260,000
R, Capital (285,000 – 25,000) 260,000

5. Using variations to bonus method, how much is the additional investment (or withdrawal of part
of investment) in order to bring the partners’ capital credit equal to 40:60 - N and R,
respectively - interest in the equity of the partnership?

N R Partnership
Adjusted Capital Balances P 235,000 P 285,000 P 520,000
N’s required capital balance (520,000 x 40%) 208,000
520,000
R’s required capital balance (520,000 x 60%) 312,000
Additional (withdrawal) (P 27,000) P 27,000 -

N shall withdraw P27,000 from initial investments and R shall make an additional
contribution of P27,000.

“Variation to the Bonus Method” is used when a partnership agreement stipulates a certain
ratio to be maintained by the partners representing their specific interests in the equity of the
partnership. This may give rise to adjustments to the initial contributions of the partner.
(See modules for further discussion)

Review Questions for Topic 2

On January 1, 2020, Peter and Jordan both sole proprietors decided to form a partnership to
expand both of their businesses. According to their agreement, they will split profits and losses
25:75 and their initial capital will also reflect that ratio.

The following are their Statements of Financial Position:

Peter Proprietor
Statement of Financial Position
December 31, 2019
LIABILITIES AND
ASSETS
EQUITY
P
Cash Accounts Payable P 85,000
70,000
Accounts Receivable 120,000 Accrued Expenses 75,000
Inventories 95,000 Notes Payable 100,000
Equipment 270,000 Peter, Capital 90,000
Accum – Dep – Equipment -205,000
P
TOTAL P 350,000
350,000

Jordan Proprietor
Statement of Financial Position
December 31, 2019
ASSETS LIABILITIES AND EQUITY
Cash P 50,000 Accounts Payable P 95,000
Accounts Receivable 130,000 Accrued Expenses 110,000
Inventories 105,000 Notes Payable 120,000
Equipment 320,000 Peter, Capital 160,000
Accum – Dep – Equipment -120,000
TOTAL P 485,000 P 485,000

The values reflected in the Statement of Financial Position are already at fair values, except for
the following accounts:
✓ Peter’s accounts receivable is now P40,000 less than what is stated in his Statement of
Financial Position.
✓ Both inventories of Peter and Jordan are now P110,000 and P90,000 respectively.
✓ Additional accrued expenses are to be established in the amount of P30,000 for
Jordan and P25,000 for Peter.
 ✓ It is also agreed that all liabilities will be assumed by the partnership, except for the notes
payable of Jordan which will be personally paid by him.
1. How much is the adjusted capital balance of Jordan upon formation?

A. P235,000
B. P115,000
C. P310,000
D. P190,000

A – Correct Answer

2. How much is the adjusted capital balance of Peter upon formation?

A. P25,000
B. P40,000
C. P90,000
D. P50,000

B – Correct Answer

3. How much should Peter invest as additional cash to be in conformity with their initial capital
agreement?

A. Peter’s contribution is sufficient.

B. P40,000
C. P38,333
D. P50,000

C – Correct Answer

Peter Jordan Partnership

Cash P 70,000 P 50,000 P 120,000
Accounts Receivable (120,000 – 40,000) 80,000 130,000 210,000
Inventories 110,000 90,000 200,000
Equipment 270,000 320,000 590,000
Accumulated Depreciation ( 205,000) ( 120,000) ( 325,000)
Total P 325,000 P 470,000 P 795,000
Accounts Payable ( 85,000) ( 95,000) ( 180,000)
Peter Accrued Expenses (75,000 +25,000) ( 100,000) ( 100,000)
Jordan Accrued Expenses (110,000 +30,000) ( 140,000) ( 140,000)
Notes Payable ( 100,000) ( 100,000)
Adjusted Capital Balances P 40,000 P 235,000 P 275,000

Let’s try to use Peter’s capital contribution first as a basis to check if Jordan has deficiency.

Peter, Capital P 40,000

Divide by profit and loss ratio of Peter 25%
160,000
Multiply by Peter’s profit and loss ration 75%
Minimum capital requirement for Jordan 120,000
Jordan’s Capital 235,000
Deficiency on Jordan’s capital contribution -
Thus, we will not use this basis.
Again, none, since the result is an
excess.
Now, let’s use Jordan’s capital contribution as a basis to check if Peter has deficiency.

Jordan, Capital P 235,000

 Divide by profit and loss ratio of Jordan 75%
313,333
Multiply by Peter’s profit and loss ratio 25%
Minimum capital requirement for Peter 78,333
Peter’s Capital 40,000
Deficiency on Peter’s capital contribution P 38,333

Thus, we will use this as a basis for Peter’s additional investment.