Financial Accounting and Reporting Partnership Formation

Module 11: Partnership Formation

Introduction

This unit covers the characteristics, the advantages & disadvantages and the accounting
process for the formation of partnership.

Although businesses may differ in form i.e., sole proprietorship, partnership and
corporation, accounting for assets and liabilities remain the same except the accounting for
equity.

Learning Objectives
At the end of the unit, students will be able to:
 Understand the characteristics of partnership.
 State the valuation of contributions of partners.
 Account for the initial investments of the partners to the partnership.
 State the peculiar accounts used in a partnership and identify the transactions that affect these
accounts.

Presentation of Content

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.

Characteristics of a partnership

1. Ease of formation - as compared to corporations, the formation of a partnership requires less

formality.

2. Separate legal personality - the partnership has a judicial personality separate and distinct
from the partners. The partnership can transact and acquire properties in its name.

3. Mutual agency - the partners are agents of the partnership the purpose of its business. As
such, a partner may legally bind the partnership to a contract or agreement that is in line with
the partnership's operations.

4. Co-ownership of property - each partner is a co-owner of the properties invested in the

partnership and each has an equal right with his partners to possess specific partnership
Financial Accounting and Reporting Partnership Formation

property for partnership purposes. However, a partner has no right to possess a partnership
property for any other purpose without the consent of his partner.

5. Co-ownership of profits - a partnership is created as a business: (a profit-oriented entity), as

such, each partner is entitled to his share in the partnership profit. A stipulation which
excludes one or more partners from any share in the profits or losses is void. (Art. 1799 of
the Civil Code of the Philippines)

6. Limited life - the creation of a partnership is basically consensual. As such, a partnership

may be dissolved:
 by the express will of any partner;
 by the termination of a definite term stipulated in the contract;
 by any event that makes it unlawful to carry out the partnership;
 when a specific thing which a partner had promised to contribute to the partnership
perishes before the delivery [Art. 1830(4)]; or
 expulsion, death, insolvency or civil interdiction of a partner.

7. Transfer of ownership - in case of dissolution, the transfer of ownership, whether to a new

or existing partner, requires the approval of the remaining partners.

8. Unlimited liability — each partner, including industrial ones, may be held personally liable
for partnership debt after all Partnership assets have been exhausted. If a partner is personally
insolvent, his share in the partnership debt shall be assumed by the other solvent partners.
 A Partnership in which all partners are individually liable is called a general
partnership.
 A partnership in which at least one partner is personally liable is called a limited
partnership. A limited partnership includes at least one general partner who maintains
unlimited liability. The others, called limited partners, may limit their liability up to
the extent of their contributions to the partnership. A limited liability partnership
usually has “LLP” in its name.

Advantages and disadvantages of a partnership

Advantage
 Ease of formation
 Shared responsibility of running the 
business
 Flexibility in decision making
 Greater capital compared to sole 
proprietorship
 Relative lack of regulation by the 
government as compared to corporations
Disadvantage
 Easily dissolved/ limited life
Unlimited liability
 Conflict among partners
Lesser capital compared to a corporation
A partnership (other than a general
professional partnership) is taxed like a
corporation.
Financial Accounting and Reporting Partnership Formation

Accounting for partnerships

The accounting for assets and liabilities remains the same regardless of the form of a business
organization. What changes is the accounting for equity.

Sole proprietorship - Owner’s capital - Mr. Rey, Capital

Partnership - Partners’ capital - Mr. Rey, Capital and Mr. Roy, Capital
Corporation - Shareholders’ equity - Share capital
Cooperative - Shareholders’ equity - Share capital

Observe the following:

 The equity of a partnership is similar to the equity of a sole proprietorship except that the
former is subdivided into the partners' capital balances.

 The equity of a corporation is similar to the equity of a cooperative, in the sense that both
have "Share capital. However, a peculiar characteristic of the equity of a cooperative is
that it includes "statutory funds." A cooperative is required by law to appropriate a
portion of its annual profit to some funds. These funds are referred to as "statutory
funds."

The following are the major considerations in the accounting for the equity of a partnership:

1. Formation - accounting for initial investments to the partnership

2. Operations - division of profits or losses
3. Dissolution - admission of a new partner and withdrawal, retirement or death of a partner
4. Liquidation - winding-up of affairs

FORMATION

A contract of partnership is consensual. It is created by the agreement of the partners which may
be constituted in any form, such as oral or written. A partnership's legal existence begins from
the moment the contract is executed, unless otherwise stipulated.
SEC Registration

When the partnership capital is P3,000 or more, in money or property, the public instrument
must be recorded with the Securities and Exchange Commission (SEC). Even if it not registered,
the partnership having a capital of P3,000 or more is still valid and therefore has legal
personality.

The SEC shall not register any corporation organized for the practice of public accountancy (The
Philippine Accountancy Act of 2004, Sec. 28).

The purpose of the registration is to set "a condition for the issuance of the licenses to engage in
business or trade. In this way, the tax liabilities of big partnerships cannot be evaded, and the
Financial Accounting and Reporting Partnership Formation

public can also determine more accurately their membership and capital before dealing with
them." (Dean Capistrano, IV Civil Code of the Philippines)

Valuation of contributions of partners

Contributions of partners to the partnership are initially measured at fair value. Fair value is
"the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date." (PFRS 13)

When measuring the contributions of partners, following additional guidance from the PFRSs
shall be observed:

Cash and cash equivalents - Face amount (PAS 7)

Inventory - Lower of Cost and Net realizable value (NRV)
NRV is estimated selling price less estimated costs of
completion and cost to sell (PAS 2)

Each partner's capital account is credited for the fair value of his net contribution (i.e.,
asset contribution less any liability assumed by the partnership). No contribution shall be valued
at an amount greater than its fair value.

A partner's subsequent share in profits (losses) shall also be credited (debited) to his capital
account. Likewise, permanent withdrawals of capital are debited to the partner's capital account.
Temporary withdrawals may be debited to the partner's drawings account. The sum of the
balances in the partners' individual capital accounts represents the total equity of the partnership.

Partners' ledger accounts

The partners' ledger accounts are:

1. Capital accounts
2. Drawings accounts
3. 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 XXX XXX Initial Capital
of capital XXX Additional investments
Share in losses XXX XXX Share in profits
Financial Accounting and Reporting Partnership Formation

Debit balance of XXX

drawings account

The partner's capital account is a real account and has a normal credit balance,

Juan dela Cruz, Drawings

Dr Cr
Temporary withdrawals XXX XXX Recurring
during the period reimbursable costs
paid by the
Temporary funds held XXX partner
to be remitted to the
partnership

The drawings account is a nominal account that is closed to the related capital account at the
end of the period. This account is a contra equity account and has a normal debit balance.

Receivable from/ Payable to a partner

The partnership may enter into a loan transaction with a partner. A loan extended by the
partnership to a partner is recorded as a receivable from the partner, while a loan obtained by the
partnership from a partner is recorded as a payable to the partner.

Illustration 1: Valuation of contributions

R and V formed a partnership. R contributed cash of P500,000, while B contributed land with
carrying amount of and fair value of P800,000. The land has an unpaid mortgage of which is
P200,000 which is assumed by the partnership.

Requirements:
a. Determine the correct valuations of the partners' contributions in the partnership books
of accounts.
b. Provide the journal entry.

Solutions:

Requirement (a):

R V Partnership
500,00
Cash 0 500,000
Land (at fair value) 800,000 800,000
500,00
Total Assets 0 800,000 1,300,000

Less: Liabilities
Financial Accounting and Reporting Partnership Formation

Mortgage payable (200,000) (200,000)

500,00
Adjusted capital balances 0 600,000 1,100,000

Requirement (b)
Date Cash 500,000
Land 800,000
Mortgage payable 200,000
R, Capital 500,000
V, Capital 600,000
To record the partners’
contribution in the partnership

Observe the following:

 The land is valued at fair value, not at the carrying amount or cost to the contributing partner.
 The mortgage on the land is recognized because it is assumed by the partnership. The
mortgage decreased the capital credit of the contributing partner.
 The sum of the partners' capital credits (i.e., P500,000 + P600,000 represents the
partnership's initial equity. This is equal to the sum of the fair values of the asset
contributions less the liability assumed by the partnership (i.e., P500,000+P800,000 -
P200,000) = P1,100,000).

Illustration 2: Valuation of contributions

R and V formed a partnership. The following are their contributions:

R V .
Cash 500,000
Accounts receivable 100,000
Building 700,000
Total 600,000 700,000

A, capital 600,000
V, capital 700,000
Total 600,000 700,000

Additional information:

 The accounts receivable includes a P20,000 account that is deemed uncollectible.

 The building is under-depreciated by P50,000.
 The building has an unpaid mortgage P100,000, but this is not assumed by the partnership.
Partner V promised to pay for the mortgage himself.

Requirements:
Financial Accounting and Reporting Partnership Formation

a. Determine the correct valuations of the partners' contributions in the partnership books of
accounts.
b. Provide the journal entry.

Solutions:

Requirement (a)

R V Partnership
Cash 500,000 500,000
Accounts receivable(100K-20K) 80,000 80,000
Building(700K-50K) 650,000 650,000
Total Assets 580,000 650,000 1,230,000

Less: Liabilities (200,000) (200,000)

1,230,0
Adjusted capital balances 580,000 650,000 00

Requirement (b)
Date Cash 500,000
Accounts receivable 80,000
Building 650,000
R, Capital 580,000
V, Capital 650,000
To record the partners’
contribution in the partnership

Observe the following

 The uncollectible is deducted in order to compute for the fair value of the accounts
receivable.
 The under-depreciation is deducted in order to compute for the fair value of the building.
 The unpaid mortgage on the building is not recognized because it is not assumed by the
partnership.

Bonus on initial investments

An accounting problem exists when a partner’s capital accounts is credited for an amount greater
than the fair value of his contributions.

For instance, a partnership agreement may allow a certain partner who is bringing in expertise or
special skill to the partnership to have a capital credit greater than the fair value of contributions.
Financial Accounting and Reporting Partnership Formation

In such case, the additional credit to the partner's capital (i.e., the 'bonus') is accounted for as a
deduction from the capital of the other partners. This accounting method is called the "bonus"
method.

Although, the credit to the partner's capital may vary due to a 'bonus,' the corresponding debit to
the asset account must still be equal to the fair value of the contribution. The difference between
the amounts credited and debited is treated as adjustment to the capital accounts of the other
partners.

Illustration: Bonus method

R and V agreed to form a partnership. R contributed P40,000 cash while V contributed

equipment with fair value of P100,000. However, due to the expertise that R will be bringing to
the partnership, the partners agreed that they should initially have an equal interest in the
partnership capital.

Requirement: Provide the journal entry to record the initial investments of the partners.

Solution:

Actual contributions Bonus method

R 40,000 (140,000 x 50%) 70,000
V 100,000 (140,000 x 50%) 70,000
Total 140,000 140,000

Date Cash 40,000

Equipment 100,000
R, Capital 70,000
V, Capital 70,000
To record the partners’
contribution in the partnership

Notes:

 The bonus given to R, i.e., capital credit P30,000 (P70,000 capital credit less P40,000 actual
contribution) is treated a reduction to the capital credit of V,
Financial Accounting and Reporting Partnership Formation

 After applying the bonus method, the total capital of the partnership is still equal to the fair
value of the partners' contributions. The debits to "Cash" and "Equipment" are equal to their
fair values. Only the amounts credited to the partners' capital accounts have varied.

Asset contribution of a Liability assumed by Credit to partner’s capital account

partner the partnership
 Initially recorded at  Initially recorded at  Either at:
fair value fair value a. Fair value (no bonus);
b. Above fair value (bonus to
the partner); or
c. Below fair value (bonus to
the other partner(s))

Variations to the bonus method

A partnership agreement may stipulate a certain ratio to be maintained by the partners

representing their specific interests in the equity of the partnership. This stipulation may give rise
to adjustments to the initial contributions of the partners. Since technically there is no "bonus"
being given to a certain partner, any increase or decrease to the capital credit of a partner is not
deducted from his co-partners' capital accounts. Instead, the capital adjustment is accounted for
as either
a. Cash settlement among the partners; or
b. Additional investment or withdrawal of investment of a partner

The following illustrations are variations to the bonus method:

Illustration 1: Cash settlement between partners

R, D and V formed a partnership. Their contributions are as follows:

R D V
Cash 40,000 10,000 100,000
Equipment 80,000
Total 40,000 90,000 100,000

Additional information:

 The equipment has an unpaid mortgage of P20,000, which the partnership assumes to repay.
 The partners agreed to equalize their interests. Cash settlements among the partners are
to be made outside the partnership.

Requirements:

a. Which partner(s) shall receive cash payment from the other partner(s)?
b. Provide the entry to record the contributions of the partners.
Financial Accounting and Reporting Partnership Formation

Solutions:

Requirement (a):

R D V Partnership
Cash 40,000 10,000 100,000 150,000
Equipment 80,000 80,000
Mortgage payable (20,000) (20,000)
Net contribution 40,000 70,000 100,000 210,000
Equal interest (210K / 3) 70,000 70,000 70,000 210,000
Cash receipt (payment) (30,000) - 30,000 -

Therefore, V shall receive P30,000 from R.

Date Cash 150,000

Equipment 80,000
Mortgage payable 20,000
R, Capital 70,000
D, Capital 70,000
V, Capital 70,000
To record the partners’
contribution in the partnership

Notes:

 The cash settlement among the partners is not recorded in the partnership's books because
this is not a transaction of the partnership but rather of the partners among themselves.
 The partnership's capital of remains the same after the cash settlement. Again, what varied
are only the credits to the partners' capital accounts.

Illustration 2: Additional investment (Withdrawal of investment)

R and V agreed to form a partnership. The partnership agreement stipulates the following:
 Initial capital of P140,000.
 A 60:40 interest in the equity of the partnership.

R contributed P100,000 cash while V contributed P40,000 cash.

Financial Accounting and Reporting Partnership Formation

Requirement: Which partner shall provide additional investment (or withdraw part of his
investment) in order to bring the partners' capital credits equal to their respective interests in the
equity of the partnership?

Solution:

Agreed initial capital 140,000

R’s required capital balance (140K x 60%) 84,000

V’s required capital balance (140K x 40%) 56,000

R V Totals
Actual contributions 100,000 40,000 140,000
Required capital balances 84,000 56,000 140,000
Additional(Withdrawals) (16,000) 16,000 -

R shall withdraw P16,000 from his initial contribution while B shall make an additional
investment of P16,000.

Application

Valuation of contributions of partners.

1. Mr. A and Ms. B agreed to form a partnership. The contributions of the partners are as
follows:

Mr. A Ms. B
Cash 20,000 30,000
Inventory 20,000
Building 40,000
Furniture and fixtures 40,000

The building has a fair value of P60,000 and is subject to a mortgage of P10,000, which the
partnership has assumed. The partnership agreement also specified that profits and losses are
to be distributed evenly.

Requirement: Provide the entry to record the contributions of the partners in the partnership
books.

Bonus method
2. A and B agreed to form a partnership. A contributed cash of P600,000, while B contributed
equipment costing but with fair value of P500,000. The partners agreed that since B will be
Financial Accounting and Reporting Partnership Formation

bringing his expertise and experience into the business, A and B shall have a 40:60 interest,
respectively. Their initial capital credits shall reflect this agreement.

Requirement: Provide the journal entry to record the initial investments of the partners.
Variations to Bonus Method

A, B and C formed a partnership. Their contributions are as follows:

A B C
Cash 500,000 200,000 100,000
Accounts 900,000
Inventories 1,000,000
Equipment 2,800,000
Totals 1,400,000 3,000,000 1,100,000

Additional information:
 Only P700,000 of the accounts receivable are deemed collectible.
 The inventories have a net realizable value of P900,000
 The equipment has a fair value of P2,000,000 and an unpaid mortgage of P800,000, which
the partnership assumes on repaying.

Case 1: Cash settlements among partners

3. The partners agreed to equalize their interests. Cash settlements among the partners are to be
made outside the partnership.

Requirements:
a. Which partner shall pay another partner in order to effect the equalization of the partners'
interests?
b. Provide the entry to record the contributions of the partners.

Case 2: Additional investment/ Withdrawal of investment

4. The partners agreed to equalize their interests. Partners shall provide additional investments
or withdraw part of their investments in order to effect the equalization of interests.

Requirement: Which partner should provide additional investment (or withdraw part ofhis
investment) in order to bring the partners’ capital credits equal to their respective interest in
the equity of the partnership?

Feedback

TRUE OR FALSE
Financial Accounting and Reporting Partnership Formation

1. You and I formed a partnership. You contributed P100 cash, while I contributed a stapler
which I bought 10 years ago for Pl,000. If we sell the stapler currently, we would probably
sell it for only P2. My capital account should be credited for Pl,000.

2. The assets contributed to (and related liabilities assumed by) the partnership are -measured in
the partnership books at carrying amount or cost to the contributing partner.

3. Mr. A contributed equipment with historical cost of P1,000,000 and fair value of P800,000 to
a partnership. If no bonus is given to any partner, Mr. A's capital account will be credited for
P800,000.

4. A bonus exists when the capital account of a partner is credited for an amount greater than or
less than the total fair value of his net contributions.

5. A bonus given to a partner is treated as an adjustment to the capital accounts of the other
partners.

Use the following information for the next two questions:

You and I formed a partnership. We both contributed P100 cash. However, we agreed that
because you have special skills which you will be bringing into the partnership, you should
receive an initial capital credit of P140.

6. Your bonus is P140.

7. After recording our contributions, my equity account in the partnership books would have a
balance of P60.

Use the following information for the next four questions:

You and I formed a partnership. You contributed P150 cash while I contributed a machine with
fair value of P50. We agreed that we should have equal interests in the partnership. Our initial
capital credits should reflect this agreement. No bonus shall be given to any of us.

8. If we agreed that the initial partnership capital should remain at P200, you should pay me
950.

9. Continuing #8 above, your initial capital credit would be P100 instead of P150.

10. If we agreed that the initial partnership capital should be P300, I should provide additional
cash of P100 to the business.

PROBLEMS:

1. On January 1, 2020, Mr. A and Ms. B formed a partnership. Mr. A contributed cash of
₱500,000 while Ms. B contributed a building with carrying amount of ₱400,000 and fair
Financial Accounting and Reporting Partnership Formation

value of ₱800,000. The building has an unpaid mortgage of ₱200,000 which is not assumed
by the partnership.

Requirement: Provide the journal entry to record the contributions of the partners.

2. A and B formed a partnership. The following are their contributions:

A B
Cash 500,000 -
Accounts receivable 100,000 -
Building 700,000
Total 600,000 700,000
A, capital 600,000
B, capital 700,000
Total 600,000 700,000

Additional information:
 The accounts receivable includes a ₱20,000 account that is deemed uncollectible.
 The building is over-depreciated by ₱50,000.
 The building has an unpaid mortgage ₱100,000, which is assumed by the partnership.

Requirement: Provide the journal entry to record the contributions of the partners in the
partnership books.

3. A and B agreed to form a partnership. A contributed ₱40,000 cash while B contributed

equipment with fair value of ₱100,000. However due to the expertise that A will be bringing
to the partnership, the partners agreed that they should initially have a 60:40 in the
partnership capital.

Requirement: Provide the journal entry to record the initial investments of the partners.

Unit Summary

 The major considerations in the accounting for the equity of partnerships are:
a. Formation;
b. Operations;
c. Dissolution; and
d. Liquidation.
 The contributions of the partners to the partnership are initially measured at fair value.
 A partner's capital balance is normally credited for the fair value of his net contribution to
the partnership. If a partner’s capital balance is credited for an amount greater than or
less than the fair value of his net contribution, there is bonus.
Financial Accounting and Reporting Partnership Formation

 Under the bonus method, any increase (or decrease) in the capital credit of a partner is
deducted from (or added to) the capital credits of the other partners. The total partnership
capital remains equal to the fair value of the partners' net contributions to the partnership.

References

Books:
Millan, Z.V (2019), Financial Accounting and Reporting (2019-2020 ed.). Bandolin Enterprise.
Ballada, W (2019), Basic Financial Accounting and Reporting (22nd ed.). Domedane Publishers