Chapter 17: Partnership Formation

• A partnership is an association of two or more persons who contribute money, property, or industry to a
common fund with the intention of dividing the profits among themselves.
o The term “person” refers to either a natural or juridical person.
• One of the major advantages of a partnership is that it permits the pooling of capital and other resources
without the complexities and formalities of a corporation. In addition, the partners operate with more
flexibility because they are not subject to the control of a board of directors.
• There are two types of partnerships:
A. General Partnership- each partner is personally liable to the partnership’s creditors if partnership assets
are insufficient to pay such creditors; partners are called general partners
B. Limited Partnership- only one partner needs to be a general partner while the remaining can be limited
partners; the limited partners’ personal properties are not put to risk, and they play no role in the
partnership management

Features of a General Partnership

1. Ease of formation- partners merely put their agreement on contribution, roles, functions, P/L distribution
into writing called partnership agreement
2. Limited Life- the possibility that the partnership operation may discontinue after a partner’s withdrawal or
death is considered a major pitfall
3. Assignment of Partner’s Interest- assignment of a partner’s interest does not automatically dissolve a
partnership; the assignee has no right to participate in the managing affairs and they are only limited to
their allocation of P/L
4. Unlimited Liability- partnership creditors may demand from any partner who was personal assets in excess
of personal liabilities
5. Mutual Agency- every partner is an agent and has the authority to act for the partnership and to enter into
contracts on its behalf
6. Separate Legal Personality- a partnership has a juridical personality separate and distinct from that of the
partners
7. Sharing Profits and Losses- P/L are divided among the partners in any manner to which they agree

Underlying Equity Theories

- Relate to how an entity can be viewed from the accounting and legal POV

A. Proprietary Theory- views the assets and liabilities as belonging to the proprietor and the profits as increase
in the proprietor’s capital; characteristics include:
o Salaries to partners are considered as distribution of income and are treated as expenses in computing
net income
o Unlimited liability of general partners extends beyond the entity to the individual partners
o Original partnership is dissolved upon the admission or withdrawal of a partner

B. Entity Theory- views the business as a separate and distinct entity possessing its own existence
independent from the individual partners; the legal life of the firms transcends the death or admission of a
partner

Written Partnership Agreement

- A written agreement is called the articles of partnership and contain the following:

1. Name of the partnership

2. The name, addresses of the partners, classes of partners, stating whether the partners are general or
limited
3. The effective date of the contract
4. The purpose/s and principal office of the business

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5. The capital of the partnerships stating the contribution of the individual partners, their descriptions and
agreed values
6. The rights and duties of each partner
7. The manner of dividing net income or loss among the partners including salary allowance and interest on
capital
8. The conditions under which the partners withdraw money or other assets for partnership use
9. The manner of keeping the book of accounts
10. The causes of dissolution
11. The provision for arbitration in settling disputes

Accounting and Financial Reporting Requirements for Partnerships

- General-purpose financial statements should use generally accepted accounting principles (GAAP) as
promulgated by the International Accounting Standards Board (IASB) and other standard-setting bodies.
- For internal reporting needs, the FS should meet the information needs and the partnership may use non -
GAAP accounting methods and have the FS in different formats.

PFRS for Small and Medium-Sized Entities

• Small and Medium-Sized Entities are those that:
o Do not have public accountability
o Publish general-purpose financial statements for external users

Accounting for Partnership Activities

A. Capital Accounts
o initial investment of each partner is recorded by debiting the assets contributed, crediting any liabilities
assumed by the firm, and crediting the partner’s capital account of the fair value of the net assets
contributed
o equity is increased by additional investments at fair value at the time of investment and any share of net
income
o equity is decreased by withdrawal of cash or other assets and share of net losses
- withdrawals of large and irregular accounts are charged directly to the capital account with the entry:
A, Capital
Cash
o at the end of the accounting period, the net income/loss in the Income Summary ledger account is
transferred to the partner’s capital accounts in accordance with the partnership contract
o a partner’s capital account may have a debit balance (deficit) which can be eliminated through additional
contributions

B. Drawings or Personal Accounts

o partnership profits are the business rewards of partners; partners generally make withdrawals in
anticipation of profits or drawings that considered salary allowance
o noncash drawings should be valued at their market values at the date of the withdrawals
- some make an exception to the rule and instead record at cost, thereby not recording a gain/loss on
these drawings
o withdrawal of regular amounts are called drawings, drawing allowances, or salary allowances and these
are usually charged to the partner’s drawing accounts; these drawings may be compared with the drawings
allowed in the partnership agreement in order to establish an accounting control over excessive drawings
o withdrawals are disinvestments of essentially the same nature as large and irregular withdrawals
o drawings accounts should be closed to the capital accounts at the end of each accounting period
o there are two classes of withdrawals:
a. capital withdrawal or permanent withdrawal- directly affect the capital account
b. personal withdrawal or temporary withdrawal- initially recorded in a drawing account; often drawings
from share of profits which will eventually be closed to capital accounts

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C. Loan Accounts
o a partner may receive cash from the partnership with the intention of repaying the amount; these loans are
debited to the Loans Receivable from Partners – the amount bears interest and the interest income is
recorded in the Income Statement
o a partner may make a cash payment to the partnership that is considered a loan rather than an increase in
the partner’s capital account balance; these loans are credited to the Loans Payable to Partners and are
normally accompanied by the issuance of a promissory note – the amount may bear interest and the
interest paid is recorded as an operating expense
o these accounts are related-party transactions for which separate footnote disclosure are required and must
be reported as a separate balance sheet item

• A partner’s capital interest is a claim against the net assets of the partnership as shown by the balance in
the partner’s capital account
• An interest in profit and loss determines how the partner’s capital interest will increase or decrease as a
result of subsequent operations

Accounting for Partnership Formation

A. Cash Investments
o Recorded at fair value/face value which is the amount payable on demand or to be collected at the
balance sheet date
o Cash in foreign currency is valued at the current exchange rate
o Cash in bank under receivership is shown at its estimated recoverable amount

B. Noncash Investment
o Recorded at the agreed value which is normally the fair value of the property at the time of investment
o Fair value is usually determined by the agreement of all partners, however in the case of a conflict
between agreed value and fair value, agreed value prevails.
o Fair value is the current market price agreed by the partners in the transaction.
o For industry/services, a memorandum entry is essential if it were no value agreed upon, otherwise a
journal entry should be required.
o Liabilities assumed by the partnership should be valued at the present value (fair value) of the remaining
cash flows.
o Individual partners must agree to the percentage of equity that each will have in the net assets of the
partnership. Generally, the capital balance is determined by the proportionate share of each partner’s
capital contribution.

A partnership may be formed in numerous ways, to wit:

a. For the first time
b. Individual versus individual (two or more persons)
c. Conversion of sole proprietorship to a partnership
i. individual versus sole proprietor
ii. sole proprietor versus sole proprietor
d. Conversion of an old partnership to a new partnership
i. partnership versus sole proprietor
ii. partnership versus partnership
e. Admission of new partners

• To record investments, we may use the Bonus Approach or the Revaluation (Goodwill) Approach.
o In the Bonus Approach, partners do not consider the intangible assets (goodwill), they only label it as a
bonus to the partner with lesser capital investment.
o In the Goodwill Approach, the difference between the partner’s investments is considered the goodwill.
o In accordance with GAAP, the Bonus Approach is used unless there is a specified agreement to use
otherwise.
o Under the Goodwill Approach, there is a different Total Agreed Capital (TAC) and Total Contributed
Capital (TCC). Under the Bonus Approach, both are the same.
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 ▪ TCC- actual contribution
▪ TAC- how much should the contribution be based on agreement among partners
o When finding the TAC for the Bonus Method, use the higher contribution.
• When a problem is silent as to whose books will be retained, the assumption is that a new set of books will
be created.
• In preparing the new set of books, equipment is recorded net of depreciation. However, allowance for
doubtful accounts is carried forward. Receivables are recorded at their gross amount.
• A partnership is not a taxable entity.

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