Unit 2: Nature and Formation of Partnership

Partnership
- Owned by 2 or more individuals
- Individual owners are called partners
- Requirement: agree to operate a business together
- Agreement: oral or written, includes profit and loss ratio
- A contract; 2 or more persons bind to contribute money, property OR industry to a
common fund with the intention of dividing profits among themselves ( Article 1767 of the
Civil Code of the Philippines)
- Supported by Articles of Co-Partnership

Articles of Co-Partnership
- Agreement in writing governing the nature and terms of the partnership contract
- Required capital of at least P3,000
- Helps in avoiding misunderstanding among partners
- Govern the formation, operation and dissolution of the partnership
- Required to be registered with the Securities and Exchange Commision (SEC)
- contains:
1. Name of partnership
2. Names, addresses of partners, classes of partners (general or limited partner)
3. Effective date of the contract
4. Purpose and principal place of business of the business
5. Capital of the partnership stating the contributions of each partners
6. Rights and duties of each partners
7. Manner of dividing profits or loss among partners
8. Conditions under which partners may withdraw money or other assets
9. Manner of keeping the books of accounts
10. Causes for dissolution and the provision for arbitration in settling disputes

Code: NOP - NAC - D - PP - C - RD- MPL - CW - MBA - CO&PASD

Characteristics of a Partnership
1. Based on contract - formed through mutual agreement; oral or written
2. Voluntary association - no one should be forced or coerced into joining a partnership
3. Mutual agency - any partner may act as an agent of the partnership in conducting its
affairs
4. Limited Life
- a partnership may be dissolved at any time by the action of the partners or by the
operation of law
- The withdrawal, death, retirement, bankruptcy, incapacity of a partner and the
admission of a new partner dissolves the partnership
- Incorporation of a partnership will also result to the dissolution of the partnership
 5. Unlimited Liability - personal assets of a general partner may be used to satisfy the
claims of the creditors of the partnership if the partnership assets are not enough to
settle the liabilities to outsiders upon liquidation
6. Co-ownership of the property
- properties contributed to the partnership are owned by the partnership
- Properties invested by a partner will be his own personal property anymore
7. Co-ownership of profit - a partner has the right to share in partnership profits as a return
on their investment
8. Legal Entity - a partnership has a legal personality separate and distinct from that of
each of the partners
9. Income Tax - partnerships are subjected to income tax rate of 30% beginning the fiscal
year 2010 with the exception of general professional partnership (i.e. partnerships
organized for the exercise of professions, e.g. CPAs, doctors, lawyers)

Code: BOC - VA - MU - LIM - UNLI LI - CO PRTY - CO PRFT- LEG ENTI - INC TAX

Advantages of a Partnership
1. Easy and inexpensive to form & dissolve
2. Capital Amount > Sole Proprietorship
3. Relative freedom & flexibility in decision-making compared to corporation
4. Better managed because more than 1 person supervises business affairs & from
combined experiences & ability of several individuals
5. Unli liability of general partners = less risky in pov of creditors

Disadvantages of a Partnership
1. Lack of business continuity because it is easy to dissolve
2. Limited capital amount compared to a corporation; Capital Amount < Corporation
3. Unli Liability - discourages many to join a partnership business
4. General partner - may be subjected to a personal liability from erroneous management
decisions made by his associates
5. Likelihood of dissension & disagreement when each partners has same authority
6. Difficulty in transferring ownership interest because consent of all partners is needed

Kinds of Partnership
1. According to activities
a. Service
b. Merchandising / Trading - purchase or sale of goods
c. Manufacturing - production of goods
2. According to liability
a. General - all partners are general partners who are liable for the partnership
debts
b. Limited - one or more general partners and one or more limited partners
3. According to objects
 a. Universa; partnership of all present property - all assets contributed to the
partnership and subsequent acquisitions become common partnership assets
b. Universal partnership of profits - the original movable or immovable property
contributed do not become common partnership assets
c. Particular partnership - ___
4. According to duration of partnership existence
a. Partnership at will - no term is specified & not formed for a particular undertaking
or venture; may be terminated any time
b. Partnership with a Fixed Term - term/period exist is agreed upon
Kinds of Partners
1. According to contribution
a. Capitalist - contributes capital in money or property
b. Industrial - contributes industry, labor, skill or service
c. Capital-Industrial - contributes money, property and industry
2. According to Liability
a. General - liability to 3rd persons extends to his private property
b. Limited - liability to 3rd persons is limited only to extent of capital contribution
3. According to Management
a. Managing Partner - manages actively
b. Silent - provides capital but generally do not participate in the management
4. Others
a. Nominal - partner in name only
b. Secret - active in business but connection with the partnership is concealed on
unknown to the public
c. Dormant partner - not active in the business & not known to the public as a
partner

Basic Features of Partnership Accounting

1. More than 1 capital & drawing accounts
2. Partners’ Loans
- partners may advance money to the partnership in the form of loans when the
business is in need of additional funds
- the account title to be credited is Loans Payable to partner or Partner, Loan
3. Partner's borrowings
- the partnership may advance money to partners other than withdrawals in the
form of loans
- the account title to be debited is Receivable from Partner or Loan to Partner.
4. Partner's salaries - partners are paid salaries for services rendered in the conduct of
partnership business.
5. Interest on investment - interest is allowed to earn on the asset investment of the
partners.
6. Division of profit and losses - net profit or net loss is to be divided among the partners
based on their agreement.
PARTNERSHIP FORMATION
Two kinds of Partnership Formation
1. Two or more individuals form a business for the first time

2. An individual forms a business with a sole proprietor or a sole proprietorship(s)

converted into a partnership

Accounting Procedures in converting a sole proprietorship form of business into

partnership
a. Revalue/adjust assets owned, liabilities owed, and capital of the sole proprietor
 b. Close the existing books of the sole proprietorship

c. Record the investment of all the partners in the new set of partnership books

Fair Market Value - amount the partners’ investments in the form of properties are recorded in
the partnership books

Memorandum Entry - entry necessary to record the investment of industrial partner

Accounts Receivable - recorded at gross amount together with the estimated allowance

2 Kinds of Entries
 1. Journal
2. Memorandum

Unit 3: Nature of Partnership Operation

2. Accounts Used in Partnerships

1. Capital account
● Debited
- Permanent withdrawals without prejudice to partnership creditors
- Retirement and/or selling of interest in the partnership
- Distribution of loss incurred by the partnership
● Credited
- Initial and/or additional investments in the form of cash, merchandise, or other assets
- Payment by a partner of partnership obligations
- Distribution of profit earned by the partnership

2. Drawing account
● Debited
- Temporary withdrawals which are deducted to the share in the partnership's profits
- Closing of credit balance to capital account due to retirement and/or sale of interest in
the partnership
● Credited
- Allowance for salaries and/or bonuses which are part of the share in the profit or loss of
the partnership
- Interest on capital balances as stipulated in the partnership agreement
- Closing of debit balance to capital account due to retirement and/or sale of interest in the
partnership

3. Loan account
● Loan to/Due from/Receivable from Partner
- A partner may be in need of cash. The partnership may extend a loan to said partner
without treating it as withdrawals. In turn, the borrowing partner will pay the loan at a
future date. The loan provided to a partner is treated as receivable and presented in the
statement of financial position as asset -current or non-current.
● Loan from/Due to/Payable to Partner
- A partner may provide financing to the partnership, as may be needed. The financing
provided by the partner is recorded as liability and is payable at a future date This
account is shown in the statement of financial position as liability - current or non-current.

3. Problems Distinctive to Partnership Operations However, problems distinctive only to

partnership operations are encountered in the following:
3.1. Recording of partner's loan account when a partner lends money to a partnership.
3.2. Recording of loan extended by the partnership to the partner/s.

3.3. Recording of the closing entries of a partnership - individual drawing accounts of

partners are not automatically closed to their capital accounts in order to maintain the
original capital balances of the partners as stated in the Articles of Co-Partnership;
drawing accounts are closed to the capital accounts only if agreed upon in the articles
of co-partnership.
3.3.1. Distributing profit or loss (Direct Method) Under the direct method, the
distribution of profit or loss is recorded directly to each of the partner's capital
Account.

3.3.2. Distributing profit or loss (Indirect Method)

Under the indirect method, the distribution of profit or loss is closed initially to
each of the partner's drawing account
4. Preparation of financial statements
The financial statements prepared for a partnership form of business is basically the
same as sole proprietorship except for the following:
4.1. Statement of Financial Position - the owner's equity section is labeled Partners'
Equity.
4.2. Income Statement - an additional section called Distribution of Net Income or Net
Loss is included. This profit or loss distribution provides a full analysis of the
distribution of earnings or losses which is presented at the bottom part of the
partnership income statement.
 4.3. Statement of Changes in Partners' Equity - a statement that reports the changes
that have taken place in the partners' equity during the period. Each partner is
provided a column heading which explains details of the changes in his/her equity
Account.

5. Rules for Dividing Profit and Loss in a Partnership business

The computation of the result of business' operation of a partnership is essentially the\
same as that of the sole proprietorship. But the distribution to individual partners of this
profit or loss is the primary objective of the accounting process.
 The income of the partnership is realized as the result of combining the contribution of
the partners in terms of capital investment, services rendered or time devoted in the
management of the business, and entrepreneurial ability or the partner's personal
business contacts and his credit rating in the business community. And if profits or
losses are to be divided fairly and equitably these stributions by the partners must be
properly considered. Therefore, the following scheme may be adapted since the
partnership's net income may be viewed as a return for:
a) services rendered - provide salaries to give recognition to the ability,
experience or time devoted by a partner to the business.
b) capital investment - provide interest to give recognition to differences in the
capital contribution given in proportion to the period such capital was actually
used.
c) entrepreneurial ability or managerial skills provide bonus which is an
incentive or special compensation which is usually based on net income.

These items are provided for as additional ways of allocating net income.

SHARE OF PARTNERS IN PARTNERSHIP PROFIT

1. Based on stipulations as stated in the Articles of Co-Partnership (also known as the profit and
loss ratio or profit ratio)
2. In the absence of no. 1, based on the partners contributed capital, but the industrial partner
shall receive a share in profit as what is just and equitable under the circumstances

The partnership may come up with their profit and loss ratio in the distribution of profits and
losses of the firm, This is the ratio in which partnership profits and losses are divided and such
ratio must be stated in the Articles of CoPartnership. In the absence of any agreement as to the
division of profits or losses, the Philippine Partnership Law provides that the share of each
partner in the profit or loss shall be in proportion to what he has contributed, i.e., in accordance
with the partners' contributed capital, but the industrial partner shall receive such shares as what
is just and equitable under the circumstances.

SHARE OF PARTNERS IN PARTNERSHIP LOSSES

1. Based on stipulations as stated in the Articles of Co Partnership (same with above)
2. In the absence of no. 1, based on profit sharing scheme as stipulated in the partnership
agreement
3. In the absence of nos. 1 and 2 above, for capitalist partner/s only, based on capital
contributions

In cases where the partners has not agreed on the method of division of partnership.profits, as
well as losses, the industrial partner/s shall be exempt from any losses.

5.1. Methods of Dividing Net Income (Profit and Loss Ratios)

 5.1.1. Equally
5.1.2. Arbitrary Ratio
5.1.2.1. Fractions
5.1.2.2. Percentages
5.1.2.3. Ratio and Proportion
5.1.3. Based on Capital Ratio
5.1.3.1. Original/Initial investment
5.1.3.2. Beginning capital balance
5.1.3.3. Ending capital balance
5.1.3.4. Average capital - most equitable method

Bonus Computation
Bonus on profit before salaries, interest and bonus.
B = Bonus % * Profit

Bonus on profit after salaries, interest but before bonus

B = Bonus % * (Profit-Salaries-Interest)

Bonus on profit after bonus.

B = Bonus % * (Profit - B)

Bonus on profit after salaries, interest and bonus.

B = Bonus % * (Profit-Salaries-Interest-B)

Ave Cap Format:

Date - Cap Bal - No. of Months Unchanged - Peso Month - Total Peso Month - Ave Cap

Unit 4: Partnership Dissolution

Dissolution of a partnership is the change in the relationship of the partners. It ends the
association of individuals for their original purpose but does not necessarily mean the
termination of the business or an interruption in its operation.
By dissolution, only the legal life of the existing partnership is terminated but the economic life is
continued. During dissolution, the partnership operation is not terminated.
CAUSES OF DISSOLUTION. (Article 1830 of the Civil Code of the Philippines):
(1) Without violation of the agreement between partners:
(a) By the termination of the definite term or particular undertaking specified in the agreement;
(b) By the express will of any partner, who must act in good faith, when no definite term or
particular is specified;
(c) By the express will of all the partners who have not assigned their interests or suffered them
to be charged for their separate debts, either before or after the termination of any specified
term or particular undertaking;
(d) By the expulsion of any partner from the business bona fide in accordance with such a
power conferred by the agreement between the partners;
(2) In contravention of the agreement between the partners, where the circumstances do not
permit a dissolution under any other provision of this article, by the express will of any partner at
any time;
(3) By any event which makes it unlawful for the business of the partnership to be carried on or
for the members to carry it on in partnership;
(4) When a specific thing which a partner had promised to contribute to the partnership,
perishes before the delivery; in any case by the loss of the thing, when the partner who
contributed it having reserved the ownership thereof, has only transferred to the partnership the
use or enjoyment of the same; but the partnership shall not be dissolved by the loss of the thing
when it occurs after the partnership has acquired the ownership thereof;
(5) By the death of any partner
(6) By the insolvency of any partner or of the partnership;
(7) By the civil interdiction of any partner; and/or
(8) By decree of court.
Dissolution dissolves the old partnership but the business continues under new partnership
agreement. The creditors of the previous partnership are still the creditor of the new partnership
formed under the new agreement.
In all cases, prior to dissolution it is necessary for the assets and liabilities of the partnership be
valued at their fair market value.
ADMISSION OF A NEW PARTNER
A partnership relationship is fiduciary - built upon the mutual trust and confidence of all partners
among each other. Hence, admission of a new partner requires consent of all the existing
partners prior to the dissolution.
A new partner may be accepted in two ways -(1) by purchase of Interest; and (2) by investment.
Purchase of Interest without asset revaluation
The existing partners may invite a friend/businessman to join the firm for business expansion or
one or both of them may be in need of cash so that they sell a portion of their interest.

● Personal transaction between the partner selling his interest and the incoming partner or
the buying partner (new partner).
● Payment of incoming partner is made directly to the selling partners and not to the
partnership. The new partner purchases interest from one or more partner in exchange
for his/her entitlement in the partnership
● The purchase of interest does not increase partnerships assets and total capitalization.
In simple words, total assets and total capital would remain unchanged.
● The purchase price paid by the new partner is not recorded in the partnership book.
● The partnership book records only a debit to capital account of the selling partner and a
credit to capital account of incoming partner.
● There would be a transfer of capital from a partner selling capital interest to a new
partner.
● Partnership does not receive any investment from the incoming partner.
● No gain or loss is recorded in the books of partnership.

Investing in the Partnership

A partner may be admitted through investment of additional asset (cash or noncash assets) to
the partnership. As opposed to purchase of interest method, the partnership assets and equity
are increased by the admission.

● Incoming and existing partner's asset must be stated at current market values or fair
values.
● Total assets and total capital of the partnership are increased.
● The transaction is between the partnership and the incoming partner.
● Bonus is the amount of capital or equity by one partner transferred to another, with no
cash consideration, for the good reputation, industry and/or business advantage of the
latter.
 ● Bonus may also represent capital credit given to a partner for his/her distinct know-how
or special service which is available only to the partnership.
● If the total agreed capital is equal to total contributed capital, it leads to recognition of
bonus. Bonus could either go to old partners or new partner.
● If the total agreed capital is greater than to total contributed capital, it leads to
recognition of undervalued asset or revaluation increase of an existing asset.
● If the total agreed capital is lower to total contributed capital, it leads to recognition of
overvalued asset or revaluation decrease of an existing asset.
● If a new partner's investment (i.e., contributed capital) is less than his/her agreed capital.
Any difference is attributable to bonus to new partner.
● If a new partner's investment (i.e., contributed capital) is greater than his/her agreed
capital. Any difference is attributable to bonus to old partners.
● If the problem is silent, the total agreed capital is equal to total contributed capital.
● Bonus to remaining partners is allocated based on their P&L ratio.

WITHDRAWAL, RETIREMENT OR DEATH OF A PARTNER

A partnership may be dissolved through withdrawal, retirement or death of a partner.

● May bring about termination of the life of the business (Liquidation)

● Business may continue without interruption with the assets of the business revalued to
reflect the present market values of the properties.

As in the case with admission of a new partner, the dissolution may be effected through: (1)
purchase of interest of the exiting partner by existing partner/s or another incoming partner; or
(2) settlement of partner's interest using partnership assets.

Purchase of Interest of Exiting Partner

This mode of dissolution due to a partner exiting the partnership is of similar nature with
admission of new partner by purchase of interest. Partnerships books are not affected by the
transaction since it is deemed personal among the parties involved. Any gain/loss realized is not
reflected in the partnership books. Only the transfer of capital/equity from the exising partner to
another is reflected.
Settlement of interest using partnership assets/ Retirement
This mode of dissolution may be deemed as purchase of interest of the exiting partner by the
partnership (i.e., the partnership itself is a party to the transaction). This results to a reduction in
partnership assets and equity. As in the case with admission, settlement to the exiting partner
may not necessarily equate to his/her capital prior to dissolution. As such, bonus to existing
partner or remaining partners may exist.

Unit 5: Partnership Liquidation

Liquidation of a partnership
- winding up of business which undergoes conversion of portion or all assets into cash
(i.e. “realization”)
- settlement of debts to creditors
- distribution of remaining assets/cash to the partners
- always results to dissolution
- Cash should be distributed first to outside creditors

Methods of Liquidation
1. Lump sum - cash distribution to partners are made only after the complete realization of
all assets and all liabilities to third party creditors have been settled
2. Installment - cash distribution to partners are made periodically over an extended period
of time. Creditors and partners receive cash under a safe payment method which
ensures that all creditors are fully protected (i.e. no cash distribution will be made unless
there is projected available cash after settlement of partnership externals debts).

Steps In Lump Sum Liquidation

1. Compute gain or loss realization and distribute among the partners using P&L ratio
● Proceeds > Book Value of Noncash assets = gain on realization
● Gain on realization increases capital balance of partners
● Proceeds < Book Value or Noncash assets = loss on realization
● Loss on realization decreases capital balance of partners
● Gain/Loss on realization are not debited/credited to income statement accounts but
are adjusted directly to the capital balances using their P&L ratio
2. Payment of liabilities and liquidation expenses
● Payment of liabilities would decrease liabilities and cash but this does not affect
capital balance of partners
● Payment liquidation expense would not be recognized as expense but is being
charged against capital balance of partners and distributed using P&L ratio.
3. Elimination of capital deficiency. This happens after absorbing loss on realization and
sharing with liquidation expense
● In case of capital deficiency, the solvent general partner will invest cash to eliminate
his deficiency. This is because of the unlimited liability characteristic of a
partnership. A partner is considered solvent when his/her personal assets exceed
personal liabilities; able to pay one’s debt
● The capital deficiency of an insolvent partner will be absorbed by the other partners.
A partner is considered insolvent when his/her personal assets are less than his/her
personal liabilities; unable to pay one’s debt
● The loss absorption potential is the maximum loss each partner can absorb and
which can eliminate him from any cash distribution
4. Distribution of cash to partners
Realization is the process of converting partnership assets into cash and distributing cash to
creditors and partners.

Statement of Partnership Liquidation Format:

Balance
Incurred Expenses
Balances
Receivable from Partner (If there is)
Balances
✔ Realization of Distribution of Gain/Loss
Balance
✔ Payment of Liabilities
Balances
Additional Cash Investment (If there is)
Balances
✔ Exercise of Offset
Balances
Absorption of Losses
Balances
✔ Final Cash Distribution

✔ Needs Financial Statement

Partnership Liquidation By Installment

● Frequently partnership assets are not realized through an instantaneous sale but may
extend over several months
● When this happens, the partners may prefer to receive the amounts due to them in a
series of installments rather than wait until all assets have been converted to cash
● Installment payments to partners are proper provided that measures are taken to insure
that all creditors are paid in full and that there is no over distribution to one or more of the
partners

Nature of Installment Liquidation

1. Noncash assets are sold on a piecemeal basis over an extended period of time
2. Cash realized is immediately distributed to partners after fully satisfying creditors’ claims
or after setting aside sufficient cash for these liabilities
3. Cash distribution to partners is considered as if it were the last because total gain or loss
on realization is not yet determined
4. Remaining unsold assets must be treated as a complete loss
5. Debit balances in capital and potential capital deficiencies are assumed uncollectible
6. Partners’ interests are reduced by cash distributions to a balance proportionate to the
partners’ P&L ratios
 7. Succeeding cash distributions are then based on the P&L ratio

Computation of Safe payments to Partners

● In installment liquidation, cash distribution to partners are authorized even before all the
losses that may be incurred and charged against the partners are known
● Considerable care is therefore, required to insure an equitable distribution of cash to
partners

Statement of Partnership Liquidation & Schedule of Safe Payments

● According to the schedule, each installment of cash is distributed as if no more cash is
forthcoming, either from sale of assets or from collection of deficiencies from partners.
Cash is therefore, distributed to a partner only if an excess credit balance in his
partnership interest.
● The Statement of Partnership Liquidation is usually supported by a schedule of safe
payments to partners, simply called Schedule of Safe Payments, prepared periodically
● No. of Safe Payment Schedules = No. of Realizations - 1

Possible losses to partners consists of the following:

1. Total value of remaining non cash assets. These assets are assumed unrealized, i.e.,
they can not be sold, hence, they are considered loss chargeable to the partners
2. Cash withheld to pay for anticipated liquidation expenses and unrecorded liabilities that
may arise. The said expenses and liabilities represent possible loss to the partners
because upon payment, the amount paid is to be correspondingly absorbed by the
partners.

Statement of Partnership Liquidation Format:

Balances
(Incurred Liquidation Expenses)
Balances
Realization 1
Balances
(Payment of Liabilities)
Balances
(Safe Payment to Partners 1)
Balances
Realization 2
Balances
(Incurred Liquidation Expenses)
Balances
(Payment of Liabilities)
Balances
Final Cash Distribution
Schedule of Safe Payment to Partners Format:
Capital Balances
Add: Loan to partner
Balances
Possible Loss to Partners
Safe Payment to Partners