Partnership Accounting

Partnership Accounting

• There are no authoritative pronouncements concerning the accounting for partnership; thus all
principles described herein have evolved through accounting practice. Partnerships are a
popular form of business because they are easy to form and they allow several individuals to
combine their talents and skills in a particular venture. In addition, partnerships provide a
means of obtaining more equity capital than a single individual can obtain and allow a sharing
of risks rapidly growing business.
• One reason for forming a partnership is that it permits the pooling of capital and other
resources without the complexities and formalities of a corporation. Generally, it is not subject
to much governmental regulation and it can operate with more flexibility because they are not
subject to the control of a board of directors.
• The major topics that need to discuss in this chapter are the following: partnership formation,
allocation of partnership income or loss, profit and loss ratio, capital investment of partners,
services rendered by partners, allocation of profit deficiencies and losses, partnership
dissolution (changes in ownership) such as admission of a new partner, partner’s death or
withdrawal, partnership liquidation: lump-sum and installment liquidation.
Definition of a Partnership

1). It states that “by the contract of partnership, two or more persons bind themselves to contribute money, property or industry to
a common fund with the intention of dividing the profit among themselves. This definition encompasses three distinct factors:
a). Association of Two or More Persons. The “persons” are usually individuals. Any natural person who possess the right to enter
into a contract can become a partner.
b). To carry On as Co-Owners. A partnership is an aggregation of partners’ individual rights. This means that all partners are co-
owners of partnership property and are co-owners of the profits or losses of the partnership.
c). Business for profit. A partnership may be formed to perform any legal business, trade or profession, or other service.
However, the partnership must attempt to make a profit, therefore, non-profit organizations may not be partnerships.

2). A type of business organization in which two or more individuals pool money, skills, and other resources, and share profit and
loss in accordance with terms of the partnership agreement. In absence of such agreement, a partnership is assumed to exit where
the participants in an enterprise agree to share the associated risks and rewards proportionately. (
http://www.businessdictionary.com/definition/partnership.html)

3). An association of two or more persons engaged in a business enterprise in which the profits and losses are shared
proportionately. (legal-dictionary.the freedictionary.com>partnership)
Characteristics of a Partnership
The following are the helpful tips to know the important characteristic 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 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
partners’ share in the earnings and in the capital.
Each partner has a right to share in the profits of the partnership. Unless the partnership agreement states otherwise, p
artners share profits equally. Moreover, partners must contribute equally to partnership losses unless a partnership agre
ement provides for another arrangement. In some jurisdictions a partner is entitled to the return of her or his capital co
ntributions.
In addition to sharing in the profits, each partner also has a right to participate equally in the management of the partne
rship. In many partnerships a majority vote resolves disputes relating to management of the partnership. Nevertheless, s
ome decisions, such as admitting a new partner or expelling a partner, require the partners' unanimous consent.
• 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 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 expirations 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. Furthermore,
a partner is an agent of the partnership. When a partner has the apparent or actual authority and acts on behalf of the business, the par
tner binds the partnership and each of the partners for the resulting obligations. Similarly, a partner's admission concerning the partners
hip's affairs is considered an admission of the partnership. A partner may only bind the partnership, however, if the partner has the auth
ority to do so and undertakes transactions while conducting the usual partnership business. If a third person, however, knows thatthe pa
rtner is not authorized to act on behalf of the partnership, the partnership is generally not liable for the partner's unauthorized acts. Mo
reover, a partnership is not responsible for a partner's wrongful acts or omissions committed after the dissolution of the partnership or a
fter the dissociation of the partner. A partner who is new to the partnership is not liable for the obligations of the partnership that occur
red prior to the partner's admission.
• 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 to the extent of their capital contributions only.
Generally, each partner is jointly liable with the partnership for the obligations of the partnership. In many states each partner is jointly
and severally liable for the wrongful acts or omissions of a copartner. Although a partner may be sued individually for all the damages as
sociated with a wrongful act, partnership agreements generally provide for indemnification of the partner for the portion of damages in
excess of her or his own proportional share
Partnership Agreement

Usually the formation of a partnership agreement must be

done at the inception of organization of the partnership. The purpose
of which is to lessen or minimize the problems that may encountered
along the way of the operations of the organization. This will serve as
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. The 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.
The significant points that must be covered by the partnership agreement are:

• 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 each 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.
• The drawings or salaries to be allowed to each partner and the disposition of partner’s salary and drawing
accounts including the penalties, if any, 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 a partner’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:
• The determination 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 a
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, whether or not
income and withdrawals are to be closed to the capital account at the end of the
accounting period, thereby, increasing or decreasing the total capital.
Partner’s Ledger Accounts

In a partnership, although it is possible to operate with only one equity

account for each partner, it is desirable that the following partner’s
accounts be maintained:
• Capital accounts
• Drawing or personal accounts
• Account for loans to or from partners
The capital account is credited for:
• Original investment
• Additional investment
• Partner’s share in the profits (sometimes this is closed to the drawing
account).
The capital account is debited for:
• Permanent withdrawal of capital.
• 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
accounts).
The drawing account is credited for:
• Partnership obligations assumed or paid by the partner.
• 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:
• Withdrawal of assets by the partners in anticipation of net income.
• Partner’s personal indebtedness paid or assumed by the partnership.
• Funds or claims of partnership collected and retained by the partner.
• 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, in 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 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. The several ways of
forming a partnership, namely:
• Formation of a partnership for the first time

a). Cash Investments. Initial cash investments in a partnership are recorded in the
capital accounts maintained for each partner. For example, Anna and Bea each invests
P150,000 cash in a new partnership. The entry to record the investments would be:

• J.E.
Cash 300,000
Anna, capital 150,000
Bea, capital 150,000
To record the investments of Anna and Bea.
b. 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 amount involved should be specified in the written
partnership agreement.
Assume that John and Jose form a partnership for the first time. Their investments are as
follows:
John Jose
(Fair value) (Fair value)
Cash P100,000 -
Merchandise inventory (cost, P20,000) 30,000
Computer equipment (cost, P60,000) 35,000
Total P100,000 65,000

J.E.
Cash 100,000
John, capital 100,000
To record initial investment of John.

Merchandise inventory 30,000

Computer equipment 35,000
Jose, capital 65,000
To record initial investments of Jose 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.
c: Bonus or Goodwill on Initial Investments. Valuation problem arises when partners agree on capital interests
that are not equal to their net assets invested. Assume that the partners agree that each partner is to receive
equal interest, even though John invested P80,000 and Jose contributed P60,000 in identifiable net assets. To
meet this condition, the capital accounts of John and Jose should be adjusted using two methods – the bonus
method or the goodwill method.

• Under the bonus method no assets is recorded in the partnership books. To equalize capital balances to
P70,000, capital transfer of P10,000 from John to Jose is made.

• J.E.
John, capital 10,000
Jose, capital 10,000
To accomplish equal capital interests of P70,000 by recording a P10,000 bonus to Jose from John.

The bonus method assumes that Jose’s business connections does not constitute a recordable partnership
asset with a measurable cost. Hence, this approach recognizes only the assets that are physically contributed
to the business (such as cash, inventory, equipment). Although these contributions determine total
partnership capital, the recognition of specific capital balances is viewed as an independent process based
solely on the partners’ agreement. Because the initial capital balances result from negotiation, they do not
need to correspond directly with the individual investments.
• When the goodwill method is used, the equalization of capital interests is accomplished by recording
goodwill of P20,000 with a corresponding increase in the capital account of Jose.

• J.E.
Goodwill 20,000
Jose, capital 20,000
To establish equal capital interests of P80,000 by recording goodwill of P20,000.

The goodwill method is based on the assumption that an implied value can be estimated mathematically
and recorded for any intangible contribution made by a partner. In the above illustration, Jose invested
P20000 less cash than John’s investment but receives an equal amount of capital according to the partners’
agreement. Proponents of the goodwill method argue that Jose’s business connections has an apparent
value of P20,000, a figure that should be included as part of this partner’s capital investment. If not
recorded, Jose’s primary contribution to the business is ignored completely within the accounting records.
Another way of forming a partnership will be explained based on the
given illustrative problem. Please refer to the excel given.

Thanks