Chapter 1 partnerships: Basic Considerations PX melded ed | Partnerships are a popular form of business because they are easy 10 form ana because they allow several individuals to combine their talents ané skills in @ particular business venture In addition, partnerships provide a means 9) more capital than a single :ndividual can obtain and allow the s harinz of’ rapidly growing businesses. Partnerships are partic ularly common professions, especially law, medicine, and accounting. These proj generally not adopted the corporate, form of business because of their | tradition of close professional association with clients and the total commit of the professional s association with clients and the total commitmen. professional s business and personal assets to the propriety of the a4 service given to clients. Definition of a Partnership ants The Partnership Law is the general governing authority for partnerships. Accour 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 te partnership. Article 1767 of the Partnership Law embodies the definition of partr It states that “by the contract of partnership, two or more persons bind themselves to contribute money, property or industry toa common fund with the intention of divid) the profits among themselves. » This definition encompasses three distinct factors: individuals. Any| a partner] 1. Association of Two or More Persons. The “persons” are usually natural person who possesses the right to enter into a contract can become AA? ‘arry. On as Co- Owners. A partnership is ar aggregation of partners’ ssdevidaal shts. This means that all partners are co-owners of partnership property and are owners of the profits o losses of the partnership. siness for Profit. A partnership may be formed to perform any legal busses, trade or profe: oF other service. However, the partnership trast attemes to make a profit; therefore, non-profit organizations may not be partnershaps. Characteristics of a Partnership Before taking up the accounting problems encountered in partnerships. tt = helpful to know the important characteristics of the partnership form of organization. Separate Legal Personality. Article 1768 of the Partnership Law states that the partnership has a juridical personality separate and distinct from that of cach of the partners. A partnership may, therefore, acquire property in its own name and may exter into contracts. Ease of Formation. The formation ofa partnership does not require as many formalities as a corporation. The partnership may be created by oral or writen 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 partnership become the property of the partnership. The right of each partner » partnership property for partnership purposes is equal to the right of each partners. Each partner has a proprietary interest in the partnership. This 2 toeach partner’s share in the earnings and in the capital. Limited Life. Any change in the agreement of the partners terminates the Contract. A partnership may also expire any time when there isa change in the of the partners due to the death, withdrawal, bankruptcy or incapacity of 2 one can be forced against his will to continue as a partner regardless of the 2= of operations. Other factors which may bring a partnership to an end are the © of the period specified in the partnership contract and the admission of 22¢8 == oem puss Mutual Agency. Each partner has an equal right to act for the partnersBiP into contracts binding upon it, as long as he acts within the normal sof . Operations. Each partner is a principal as well as an agent of thePartnerships: Basic Considerations and Organizations 3 inlimited Liability. F ; 7 apa eek any beheld personally liable forall the debts ofthe of partnership liabilities. There ied Roel eee a et econ 3 a ny 7 » A special type of partnership. c: partnership, wh : ype of partnership, called limited ee Partners are allowed to limit their personal liabilities to the extent of their capital contributions only. a % Entity Versus Proprietorship Theories es theory views the assets of'a business as belonging to the proprietor, abilities 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 are usually viewed as a combination of two or more proprietorshipé, 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 partnerships and proprietorships (.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 eared by the partnership is usually viewed as income to the “entity” with each partner entitled toa distributive share of the income. Partnership Agreement The formulation ofa 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, ifnot 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. Among the more significant points that must be covered by the partnership sagreement are:& f N Chapter 1 . Names of the partners, and the name and nature of the partnership; . The date on which the partnership contract takes effect and the duration of the contract; . The capital to be invested by cach 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); The authority, the rights and duties of each partner; . The accounting period to be used, the nature of accounting records, preparation of financial statements, and auditing of partnership books. . The method of sharing profits and losses including the frequency of income measurement and distribution to partners. ae - The drawings or salaries to be allowed to each partner and the disposition of partner’s salary and drawing accounts including the penalties, ifany, 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 apartner’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 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: nN bd . Thedetermination of the current fair values to be assigned to the noncash assets initially invested to the partnership. The ascertainment of the individual partner’s initial interest in the partnership capital. : The formulation of the plan for sharing in the profits or losses. The determination of the methods to compute the interest of a withdrawing partner as 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. The determination of the closing procedures to be followed, that is, W hether oe not income and withdrawals are to be closed to the capital account at ee i of the accounting period, thereby, increasing or decreasing the total capipartner's Ledger Accounts Ina partnership, although it is possible to operate with only one equity account for each partner, itis desirable that the following partner’s accounts be maintai ned: 1. Capital accounts 2, Drawing or personal accounts 3, Account for loans to or from partners Capital and drawing accounts. The original investment of each partner 1S 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 netassets 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. A partner's equity is increased by the additional investment of cash or other] property and bya share in the partnership profit. A. partner’s equity is decreased by the withdrawal of cash or other assets and by a share inthe partnership loss. Normally, increases or decreases in capital that are interpreted as permanent capital changes are recorded directly in the capital account. Withdrawals, which are considered equivalentto salaries, made by the partner in anticipation of profits, and other increases or decreases of relatively minor amounts are recorded in the drawing account. At the end of the accounting period, the debit and credit balances in the drawing account are then closed to the respective partner's capital account, Also, during this period, the profit or loss as shown by the Income Summary account is distributed in accordance ‘vith the profitand oss 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 drawing 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).ee = Chapter 1 The capital account is debited for @ Permanent withdrawal of capital b. Debit balance of the drawing account at the end of the period. © Partner's share in the losses (sometimes this is closed to the drawing account). The drawing account is credited for: 4. Partnership obligatior sumed or paid by the partner. 5. Personal funds or claims of partner collected and retained by the partnership. ©. Periodic partner's salaries depending on the accounting and disbursement procedures agreed upon ‘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. Funds or claims of partnership collected and retained by the partner. c 1.oans to and from partners. A withdrawal by a partner ofa substantial amount with the assumption of its repayment to the firm may be debited toa 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 asa 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 ofa partnership for the first time. 2. Conversion ofa sole proprietorship to a partnership. . a. A sole proprietor allows another individual, who has no business of his ow" to join his business. b, Two ormore sole proprietors form a partnership. 3, Admission of anew partner (This is discussed in Chapter 3).Partnerships: Basic Considerations and Organizations a Partnership Formation for the First Time ~ Initial Invest: vestments Cash Investments Initial cash in i i Fae ao ei pare egaiP ae recorded inthe capital account masntained z ie s and Besa each invests P100,0( s ; partnership. The entry to record the investments would be. 0,000 cash in a new 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. INustration. Assume that Manny and Noynoy form a partnership for the first time Their investments are as follows: Manny Noynoy (Fair Value) (Fair Value Cash P70,000 - Merchandise inventory (cost, P10,000) P20,000 Computer equipment (cost, P50,000) 30,000 70,000 100 Total8 Chapter 1 ‘The journal entries to record the investments are as follows: 70,000 To record initial investment of Manny Merchandise inventory 20,000 Computer equipment 30,000 50,000 __ Noynoy, capital To record initial investments of Noynoy 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 on 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 ag th each partner is to receive equal interest, even though Manny invested P70. .d, P50,000 in identifiable net assets. To meet this conditi Noynoy contribute capital accounts of Manny and Noynoy should be adjusted using two approaches — the bonus approach or the goodwill approach. Under the bonus approach no assets is recorded in the partnership books. Toe. capital balances, capital transfer of P10,000 from Manny to Noynoy is ma¢e. Tt entry necessary is as follows: Manny capital 10,000 Noynoy capital To accomplish equal capital interests of P60,000 by recording a P10,000 bonus to Noynoy from Manny. 10,000 ccomplished ital account When thz goodwill approach is used, the equalization of capital interest by recording goodwill of P20,000 with a corresponding increase in the ¢ of Noynoy. The entry 1s: Gocdwill 20,000 50,000 Nesnoy capital : ' To establish equal capital interests of P70,000 by recoraing goodwill of P20,000.Partnerships: Basic Considerations and Organizations eens 9 ie HP A decision to use one approach over the other will depend on the partner's a emnent. In the absence of any agreement, the bonus ap, . fe ta ‘ proach is preferab| method. The justification to this is discussed in detail id Chapter oe oO Sole Proprietor and Another Individual Forma 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. Assume that Jose has been operating a retail store fora number of years. A statement of financial position on July 1, 2011 is prepared for Jose Company as follows: Mlustration 1-1 Jose Company Statement of Financial Position July 1, 2011 ae P 60,000 Accounts receivable Py on Inventory on A 70¥ Equipment P40, acto Less: accumulated depreciation 4,000 36, 216,000 Total assets P216,000 Liabilities and Capital ot Accounts payable yer Jose capital i 216,000 Total liabilities and capital10 Chayper | Jose needs additional capital to mect the increasing sales and offers Pedro an interess in the business. Jose and Pedro agree to form a partnership to be known as JP Partners ip, Jose’s business is audited and its net assets arc appraised. The audit and appraica\ shows the following: Allowance for bad debts of P5,000 is to be provided. Inventory is to be recorded at its market value of P#0,000. The equipment has a fair value of P35,000 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, 2011 Pedro contribute P100,000 cash for 2 one-third Capital interest. The JP Partnership is to acquire all of Jose’s business and assurne 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) 2011 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 of Jose. (2) Cash 100,000 59 900 Pedro, capital To record investment of Pedro.Parinerships: Basic Considerations and Organizations 1 After the formation, the statement of financial position of the newly formed partnership f p TSN ix Mlustration 1-2 JP Partnership Statement of Financial Position July 1, 2001 Assets ee : i Cash P160,000 Accounts receivable PS0,000 ; Less: Allowance for bad debts 5,000 45,000 Inventory 80,000 Equipment 35,000 Total assets 320,000 Liabilities and Capital Accounts payable P 88,000 Jose capital 132,000 Pedro capital 100,000 Total liabilities and capital P320,000 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.enna ee Using the procedures, the journal entries to record the formation of the partnership are: Books of Jose (Sole Proprietorship): 2011 July (1) Inventory Accumulated depreciation — Equipment Equipment Allowance for bad debts Accounts payable 5 Jose, Capital To adjust assets and liabilities of Jose. 10,000 4,000 88,000 5,000 132,000 (2) Accounts payable Allowance for bad debts Jose, Capital Cash Accounts receivable Inventory Equipment To close all the adjusted balances of the accounts. New Books of the Partnership ‘ 2011 ¢ July! : (1) Cash . 60,000 Accounts receivable 50,000 Inventory 80,000 Equipment 35,000 Accounts payable Allowance for bad debts Jose, Capital To record investments of Jose. (2) Cash 100,000 Pedro, Capital To record cash investment of Pedro. 5,000 5,000 2,000 2,000 60,000 50,000 80,000 35,000 88,000 5,000 132,000 100,000at ae ee Le. Two Proprietors Form a Partnership The accounting procedures described in the preceding section are also applicable when two or more proprictorships Join together to form a partnership. There should 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 assi gned 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, 2011, 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 on the next page. Illustration 1-3 ; Gerry Company Statement of Financial Position June 30, 2011 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 Gerry Capital 26,000 Total liabilities and capital 29,000 Henry Company Statement of Financial Position June 30, 2011 Assets Cash P4000 Accounts receivable 8,000 Merchandise inventory 10,000 Furniture and fixtures 9,000 Total assets _P31,00 Liabilities and Capital _ Accounts payable P6,000 Henry capital 25,000 Total liabilities and capital P31,000~ - - Chapter 1 Pde cuaatitious agtved by the partners for purposes of determining their interests in the paetership are presented below: & (0% ofaccounts receivable is to be set up as uncollectible in each book. & Merchandise inventory of Henry is to be increased by P'1,000. © The furniture and fixtures of Gerry and Henry are to be depreciated by P600 aud P90O respectively. Books of Henry are used as the Partnership Books. If the books of Henry are to deusad as the parmership books, the accounting procedures to record the formation of the partnership are: Books of Gerry 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. fe , journal entries to record the formation of the partnership, using the above accounting are: Books of Gerry 2011 June 30 1) Gerry capital 1,600 Allowance for bad debts 1,000 Accu. depreciation — furniture and fixtures 600 To record adjustments of assetsprmerships: Basic Considerations and Onganizations (2) decounts payable 3.000 Allowance for bad debts 1.000 docu, depreciation ~ furniture and fixtures 600 Gerry capital 24.400 Cash Accounts receivable Merchandise inventory Furniture and fixtures To close the books. Books of Henry (Now the books of the partnership) 2011 June 30 {1) Merchandise inventory 1,000 Henry capital 700 Allowance for bad debts Accu. depreciation — furniture and fixtures To adjust assets of Henry. (2) Cash 5,000 Accounts receivable 10,000 Merchandise inventory 8,000 Furniture and fixtures 5,400 Accounts payable Allowance for bad debts Gerry capital To record investments of Gerry. 5.000 10,000 8,000 6,000 300 New Partnership Books will be used. \f new books are to be opened for the partnership, the following accounting procedures may be used to record the formanon ofthe 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 Hook of the Partnership Record the investments of Gerry, his adjusted assets and liabilities. 2, Record the investments 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 2011 June 30 (1) Gerry capital 1,600 Allowance for bad debts Accu, depreciation ~ furniture and. fixtures To record adjustments of assets. (2) Accounts payable 3,000 Allowance for bad debts 1,000 Accu. depreciation ~ furniture and fi tures: 600 Gerry capital 24,400 Cash Accounts receivable Merchandise inventory Furnitures and fixtures To close the books, Books of Henry 2011 June 30 (1) Merchandise inventory 1,000 Henry capital 700 Allowance for bad debts Accumulated depreciation ~ furn. and fixt. To record adjustments of assets 1,000 600 800 900Partnerships: Basic Considerations and Organizations (2) Accounts payable Allowance for bad debts Accumulated depreciation — furn, and fixt Henry capital ‘ a. Cash Accounts receivable Merchandise inventory Furniture and fixtures To close the books. New Books of the Partnership 2011 June 30 (1) Cash Accounts receivable Merchandise inventory Furniture and fixtures Accounts payable Allowance for bad debts Gerry capital To record the investments of Gerry. (2) Cash Accounts receivable Merchandise inventory Furniture and fixtures Accounts payable Allowance for bad debts Henry capital To record the investments of Henry 6,000 800 900 24,300 5,000 10,000 8,000 5,400 4,000 8.000 11,000 8,100 4,000 8,000 11,000 9,000 3,000 1,000 24,400 6,000 800 24,300 17 Take note that the Furniture and Fixtures accounts are recorded net of the accumulat depreciation.18 eS Chapter 1 The statement of financial positio : a The sta Position of the partnership after the formation is ay Mlustration 1-4 GH Partnership Statement of ncial Position June 30, 2011 Cash 9,000 Accounts receivable Elen Less: Allowance for bad debts 1400 oe Merchandise inventory —— 13,500 Furniture and fixtures Total assets P5770, Liabilities and Capital Accounts payable P9,000 Gerry capital 24.40 Henry capital 24,300 PS7,700 Total liabilities and capital 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 a 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 ane isalso the value of the partnership’s net assets. The fundamental accounting equlio™ (assets less liabilities equals capital) is used often in partnership accounting Each partner’s capital interest recorded does not necessarily have to equal his ae contribution. The partners may decide to divide the total capital equally Oa api the actual contributions, The key point is that the partners may allocate parte contributions in any manner they desire, The accountant must be sure that I agree to the allocation and must then record it accordingly.