CHAPTER 17 PARTNERSHIP FORMATION

Introduction
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
business 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 businesses. Partnerships are fairly common in the service of
professions including law. medicine, and accounting. Historically, these
professions have generally not adopted the corporate form of business because
of their long-standing tradition of close professional association with clients and
the total commitment of the professional business and personal assets to the
propriety of the advice and service to clients.
Partnership Defined
A partnership is on 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. The ferm
"persons" refers to natural or juridical which may either be an
Individual, a corporation, and even other partnerships. Typical
example of partnership includes professional services such as the
practice of law or accountancy, real estate development companies
and a variety of small manufacturing concems.
Reasons for Forming a Partnership
The basic consideration of prospective owners) of a business is the
various attributes of the different forms of business organizations as
their basis in selecting the one that they believe best meet their
organizational objectives and personal goals. A form suitable for one
set of business objectives may not be appropriate for another. It is
possible for a firm to start as a sole proprietor and, as the business
and personal environments change. to move to a partnership form,
and ultimately, to incorporate.
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, A partnership is easier and less costly to
establish than a corporation and is generally not subject to much
governmental regulation. In addition, the partners may be able to
operate with more flexibility because they are not subject to the
control of a board of directors.

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Types of Partnerships
There are two types of partnerships: (1) general partnerships and
(2) limited partnerships:
General Partnerships
General partnerships are those in which each partner is personally
liable to the partnership's creditors if partnership assets are not
sufficient to pay such creditors. Such partners are referred to as
general partners. Chapters 19 to 23 of this book focus on this kind of
partnership.
Limited Partnerships
In this kind of partnerships, only one partner needs to be a general
partner. The remaining partners can be limited, which means that
their obligations to creditors are limited to their capital
contributions. Thus, their personal properties are not put into risk
and they play no role in the partnership management, which is full
responsibility of the general partner.

Features of General Partnerships

General Partnerships have the following unique features:
1. Ease of Formation. The partners merely put their agreement
into writing concerning who contributes assets or services,
their role and functions, and how profits and losses are
allocated. This written document is called the partnership
agreement. In some cases, partnership may also be created by
oral agreement between two or more persons or maybe
implied by their agreement.
2. Limited Life. The possibility that the operations of a
partnership could not continue after the withdrawal or death
of a partner was considered a major pitfall of this form of
business organization.
3. Assignment of Partner's Interest. Assignment of partner's
interest does not automatically dissolve a partnership. Since a
partner's relationship to the other partners is a personal one,
an assignment of a partner's interest does not automatically
admit the assignee into the partnership. The assignee has no
right to participate in managing the affairs of the partnership,
their right are only limited in the allocation of profit and loss
and the right to receive assignor's interest in the event of
dissolution.
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 4. Unlimited Liability. The term "general partnership" as
previously discussed refers to a firm in which all the partners
are responsible for liabilities and have all the authority to act
on his behalf. Partnership creditors having difficulty in
collecting from the partnership may request payment from any
partner who has 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. However, acts beyond the normal scope of
business operations such as obtaining loan by a partner,
generally do not bind the partnership unless specific authority
has been given to the partner.
6. Separate Legal Personality. Partnership law provides that
partnership has a juridical personality separate and distinct
from that of each partner.
7. Sharing Profits and Losses. Profit and losses are shared
among the partners in any manner to which they agree.

Underlying Equity Theories (Proprietary and Entity Theories)

Equity theories relate to how an entity can be viewed from the
accounting and legal point of view. These theories deal with the
question of who the entity is. Partnerships then had affected and
influenced by the following theories:
1. Proprietary theory looks at the entity through the eyes of the
owner. It views the assets of a business as belonging to the
proprietor. The liabilities of a business are debts of the proprietor.
The profits generated there from are viewed as an increase in the
proprietor's capital. Characteristics of this theory can be
demonstrated by the following:
a. Salaries to partners are considered as distribution of income
rather as a determinant of net income (treated as expenses in
computing net income).
b. Unlimited liability of general partners extends beyond the
entity to the individual partners.
c. Original partnership is dissolved upon the admission or
withdrawal of a partner.
In practice, proprietorships are treated as separate entities, even
though. In theory, they are not, it should be noted, that this type
of theory primarily affected most partnerships.
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2. Entity theory views the business as a separate and distinct entity
possessing its own existence apart from the individual partners.
Profits earned by the partnership are usually viewed as profit to the
"entity" with each partner entitled to a distributive share of the
profit. The legal life of firms in this fashion transcends the death or
admission of a partner. In partnership agreements for instance, the
so-called big accounting firms usually provide for the continued
existence of the partnership beyond the death of a partner.

Written Partnership Agreements (Articles of Partnership)

While it is perfectly acceptable to have on oral partnership
agreement, it is preferable to commit such agreement in writing.
Lapses in memory and future misunderstandings are usually
avoided when agreements are written. A written agreement is called
the articles of partnership and usually provides for the following:
1. Name of the partnerships;
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;
5. The capital of the partnerships, stating the contribution of
individual partners, their description 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; and
11. The provision for arbitration in setting disputes.
Accounting and Financial Reporting Requirements for
Partnership
Most partnerships are small or medium-sized entities, although
there are some large partnership entities. Partnership does not issue
stock and thus the information needs of a partnership are typically
different those of corporations that have stockholders. A partnership
has much more flexibility to select specific accounting measurement
and recognition methods and specific financial reporting formats

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If a partnership wishes to issue general-purpose financial
statements for external users such as credit grantors, vendors, or
others, then the partnership should use generally accepted
accounting principles (GAAP) as promulgated by the International
Accounting Standards Board (IASB) and other standard-setting
bodies, and the accepted accounting principles (GAAP) independent
auditor can issue an opinion that the statements are in accordance
with GAAP.
If a partnership has only internal reporting needs, then the
accounting and financial reporting should meet those internal
information needs of the partners. In this case, the partnership
may use non-GAAP accounting methods and have financial
reports in a format different from those required under GAAP.
For example, some partnerships use the accounting methods
prescribed by tax laws, thereby generating tax-based financial
reports. Some partnerships use the cash-based accounting system,
often with some-adjustments, so the financial reports provide
specific cash flow and cash positions. And other partnerships may
use accounting methods that are close to GAAP, with some other
adjustments that fit the information needs of the partners, such as
recognizing increases in the fair value of nonfinancial assets at the
time of the admission of a new partner.
In these cases, if the financial statements are presented to users
external to the partnership, such as banks, vendors, or
regulatory bodies, it should be clearly Identified on the
statements what specific accounting methods were used by the
entity so that the users are informed that the information
presented in the financial statements does not conform to GAAP.
An independent accountant's opinion on these financials would also
have to disclose the specific accounting methods used or the
deviations from GAAP that affected the amounts reported in the
financial statements. It is up to the partners to determine their
financial information needs and then the partnership accountant
apllies the necessary accounting measurement, recognition, and
reporting methods that meet the partners financial information
needs.
Philippine Financial Reporting Standards for Small and
Medium-Sized Entities
In 2010, the International Accounting Standards Board (IASB)
Issued "International (Philippine) Financial Reporting Standards for
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Small and Medium-sized entities", more commonly known as PFRS
for SMEs, SMEs are defined as those entitles that:
1. Do not have public accountability (le., do not have stock or
issue bonds in a public capital market and
2. Publish general-purpose financial statements for external
users.
The standard presents the definitions of items and accounting
concepts that are quite. similar to those already in the international
financial accounting and reporting standards, except that less detail
and fewer disclosures are mandated and more flexibility is provided
for the formats of the financial statements.

Accounting for Partnership Activities

Accounting for partnership differs from accounting for a sole
proprietor or a corporation as far as sharing of profit and loss and
the maintenance of the partner's ledger accounts. To maintain
partnership accounting records, it might be possible to have one
ledger account for each partner, and the usual practice is to maintain
three types of accounts. These partnership accounts consist of:
1. Capital accounts.
2. Drawings or personal accounts, and
3. Accounts for loans to and from partners.
Capital Accounts
The initial investments by each partner is recorded by debiting the
assets contributed, crediting any liabilities assumed by the firm, and
crediting the partner's capital account at the fair value of the net
assets (assets minus liabilities) contributed.
Partner's equity is increased by additional investments at fair value
at the time of investment and any share of net income.
Partner's equity is decreased by withdrawal of cash or other assets
and share of net losses. Withdrawals of large and irregular accounts
are ordinarily charged directly to the withdrawing partner's capital
account. The entry for such a withdrawal is:
A, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxx
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxx
Withdrawal of cash
Following are the items that affect capital account:
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 Capital Accounts
Permanent or capital withdrawal Initial/Original Investment
Drawings in excess of a specified amount Additional investment
Withdrawal of large and irregular Share in net income (this may be
accounts credited to drawing accounts)
Share in net losses (this may be debited to
drawing accounts)
Closing of a net debit balance in the
partner's drawing account

At the end of each accounting period, the net income or loss in the
partnership's Income Summary ledger account is transferred to
the partners' capital accounts in accordance with the partnership
contract.
On occasion, a partner's capital account may have a debit balance,
called a deficiency or sometimes called a deficit, which occurs when
the capital accounts debit balance is greater than the credit
balance. A deficiency is usually eliminated by additional capital
contributions.

Drawings or Personal Accounts versus Capital Withdrawals

Partnership profits are the business rewards of partners, so
partners do have take-home pay as do the employees of the
partnership business. So, partners generally make withdrawal of
assets from the partnership in anticipation of profits or drawings
that are considered salary allowances. Noncash drawings should be
valued at their market values at the date of the withdrawals. A
few partnerships make an exception to the rule of market value for
partners' withdrawals instead record it at cost, thereby not
recording a gain or loss on these drawings.
Active partners commonly withdraw regular amounts of money on a
weekly or monthly basis. Such withdrawals are called drawings,
drawing allowances, or sometimes salary allowances and they are
usually charged to the partners' drawing accounts. For example,
if B and C withdraw P10,000 from the partnership each month, they
would record the monthly withdrawals as follows:
B, Drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Drawing allowance for January

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 C, Drawing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Drawing allowance for January
Drawing accounts provide a record of each partner's drawings
during an accounting period. These drawings may be compared
with drawings allowed in the partn partnership agreement in
order to establish an accounting control over excessive drawings
(Drawings are also a factor in many profit and loss sharing
agreements, refer to Chapter 2.) If B draws P10,000 each month
during the year, the drawing account is closed at the end of he year
by the following entry:
B, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
B, Drawing. . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Close drawing account
Following are the items that affect drawing account:
Drawing Accounts
Personal withdrawals in anticipation
of profits (temporary withdrawal)
Periodic withdrawal

Regardless of the name given to regular withdrawals by partners,

such withdrawals are disinvestments of essentially the same
nature as large and irregular withdrawals. Drawing accounts
should be closed to the capital accounts at the end of each
accounting period before a partnership balance sheet is prepared.
Considering the above discussions, there are two classes of
withdrawal
1. Capital withdrawal or permanent withdrawal - They directly
affect the capital account balance because they arise mostly
from withdrawals of investment be original or additional.
2. Personal withdrawal or temporary withdrawal or drawing
accounts. These are initially recorded in a drawing account.
More often these are drawings from shore which will
eventually be closed to capital accounts.

Loan Accounts
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Rarely, a partner may receive cash from the partnership with the
intention of repaying this amount. Such a transaction may be
debited to the Loans Receivable from Partners ledger account
rather than to the partner's drawing account. Unless all partners
agree otherwise, these loans should bear interest, and the interest
income is recognized on the partnership's income statement.
On the other hand, 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. This transaction is recorded
by a credit to Loans Payable to Partners and normally
accompanied by the issuance of a promissory note.
Again, unless all partners agree otherwise, the partnership is
obligated to pay interest on the loan to the individual partner.
Note that interest is not required to be paid on capital
Investments unless the partnership agreement states that
capital interest is to be paid. The partnership records interest on
loans as an operating expense. The following entry made to record
a P50.000, 10 percent, one-year loan from C to the partnership on
March 1, 20x6

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Loan Payable to C . . . . . . . . . . . . . . . . . . . . . . . 120,000
Sign loan agreement with partner C.
Loan receivable from partners are displayed as assets in the
partnership balance sheet and loans payable to partners are
displayed as liabilities. The classification of these items as current
or non-current usually depends on the maturity date. Since these
accounts are related-party transaction for which separate
footnote disclosure is required and it must be reported as a
separate balance sheet item.
If sizeable unsecured loan has been made by a partnership to a
partner and settlement appears doubtful, it is proper to offset the
receivable against the partner's capital account balance. If this is not
done, partnership total assets and told partners' equity may be
deceptive,

Capital Interest Opposed to Profit interest

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In partnership agreement, the partners must identify that there is a
difference between a partner's capital interest and his/her
interest in profits and losses subsequently reported by the
partnership. A partner's capital interest is a claim against the net
assets of the partnership as shown by the balance is the
panther's capital accounts; an interest in profit and loss
determines how the partner's capital interest will increase or
decrease as a result of subsequent operations. For example,
partners may agree that an individual partner is to receive a one-
fourth capital interest and a profit and loss interest of one-third

Accounting for Partnership Formation

Cash Investments
All properties brought into the partnership or acquired by the
partnership are partnership property,
Cash investments in accordance with the current standards being a
financial asset are recorded at fair value most often known as face
valve as far as cash valuation is concerned, which is the amount
payable on demand or to be collected of the balance sheet date.
Cash denominated in foreign currency is valued at the current
exchange rate, while cash in bank under receivership should be
shown at its estimated recoverable amount.
Noncash Investment
At soon as property other than cash is invested in a partnership,
noncash property is recorded at the agreed value which is normally
the fair value of the property at the Ime of investment.
Theoretically, the fair value should be determined by independent
valuations, but as for practicability is concerned, the fair value of
noncash assets in determined by agreement of all partners. The
amounts involved should be specified in the written partnership
agreement.
It should be noted that in case there is a conflict between agreed
value and fair value, agreed value prevails.
Once services are contributed to the partnership, a memorandum
entry is essential if it were no value agreed upon, otherwise a
journal entry would be required.
Liabilities assumed by the partnership should be valued at the
present value (fair value) of the remaining cash flows.
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The 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.
The valuation of net assets achieves equity among partners, an
objective repeatedly stressed in partnership accounting. If these
valuation principles (for cash, noncash property and liabilities) were
not followed, then, the subsequent operations do not reflect the true
earnings of the partnership, and certain partners are treated
inequitably.
In the final analysis of capital interest, the partnership must clearly
distinguish between capital contributions and loans made to the
partnership by individual partners. Loan arrangements should be
evidenced by promissory notes or other legal documents necessary
to show that a loan arrangement exists between the partnership and
an individual partner
A partnership may be formed in numerous ways, to wit
1. For the first time:
a. Individual versus Individual (two or more persons)
2. Conversion of a sole proprietor to a partnership:
a. Individual versus Sole Proprietor
b. Sole Proprietor versus Sole Proprietor
3. Conversion of an old partnership to a new partnership:
a. Partnership versus Sole Proprietor
b. Partnership versus Partnership
4. Admission of new partners (to be discussed in Chapter 21)
The guidelines are to be strictly followed regarding formation:
Individual versus Individual
Books of Partnership
Individua Books
l
Adjusting entries . . . . . . . . . . . . . . . . . . . . . . N/A
Closing entries (real accounts) . . . . . . . . . N/A
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . Yes
* Where: N/A – because there are no books of individuals

Individual versus Sole Proprietor (Old set of books is used;

retain books of Sole Proprietor)

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 Books of * Books of
Individua Sole Prop.
l
Adjusting entries . . . . . . . . . . . . . . . . . . . . . . . . N/A Yes
Closing entries (real accounts) . . . . . . . . . . . N/A No
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes **
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes
* Partnership Books
** Investments of individual; additional investments or withdrawals of
sole proprietor.
Individual versus Sole Proprietor (New set of books is used)
Books of Books of * New Set
Individua Sole of Books
l Prop.
Adjusting entries . . . . . . . . . . . . . N/A Yes
Closing entries (real accounts) N/A Yes
Investments . . . . . . . . . . . . . . . . . . Yes **
Balance Sheet . . . . . . . . . . . . . . . . Yes
* Partnership Books
** Investments of individual; additional investments or withdrawals of
sole proprietor.
Sole Proprietor versus Sole Proprietor (Old set of books is used:
retain books of one of the Sole Proprietors
Books of * Books of
Individua Sole Prop.
l
Adjusting entries . . . . . . . . . . . . . . . . . . . . . . . . N/A Yes
Closing entries (real accounts) . . . . . . . . . . . N/A No
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes **
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes
*Partnership Books
** Additional investments or withdrawals of sole proprietor.
Sole Proprietor versus Sole Proprietor (New set of books is
used)
Books of Books of * New Set
Sole Sole of Books
Prop. Prop.
Adjusting entries . . . . . . . . . . . . . . Yes Yes
Closing entries (real accounts) . Yes Yes
Investments . . . . . . . . . . . . . . . . . . . Yes **
Balance Sheet . . . . . . . . . . . . . . . . . Yes
* Partnership Books
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** Additional investments or withdrawals of sole proprietor.
Partnership versus Sole Proprietor (Old set of books is used:
retain books of Partnership)
Books of * Books of
Sole Partnership
Prop.
Adjusting entries . . . . . . . . . . . . . . . . . . . . . . . . Yes Yes
Closing entries (real accounts) . . . . . . . . . . Yes No
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes **
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes
* Partnership Books
** Additional investments or withdrawals of sole proprietor.
Partnership versus Sole Proprietor (New set of books is used)
Books of Books of * New Set
Sole Prop. Partnership of Books
Adjusting entries . . . . . . . . . . . . Yes Yes
Closing entries (real accounts) Yes Yes
Investments . . . . . . . . . . . . . . . . . . Yes **
Balance Sheet . . . . . . . . . . . . . . . . . Yes
* Partnership Books
** Additional investments or withdrawals of sole proprietor.
Partnership versus Partnership (Old set of books is used; retain
books of one of the Partnership)
Books of * Books of
Partnershi Partnership
p
Adjusting entries . . . . . . . . . . . . . . . . . . . .Yes Yes
Closing entries (real accounts) . . . . . . . Yes No
Investments . . . . . . . . . . . . . . . . . . . . . . . . . Yes **
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . Yes
* Partnership Books
** Additional investments or withdrawals of sole proprietor.
Partnership versus Partnership (New set of books is used)
Books of Books of * New Set
Sole Partnership of Books
Prop.
Adjusting entries . . . . . . . . . . . . Yes Yes
Closing entries (real accounts) Yes Yes
Investments . . . . . . . . . . . . . . . . . . . Yes **
Balance Sheet . . . . . . . . . . . . . . . . . Yes
* Partnership Books
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** Additional investments or withdrawals of sole proprietor.
Illustration 17-1: Individual vs. Individual
Illustrative examples are presented below to appreciate the different
ways of forming a partnership.
The following items are being invested to form AB Partnership
Agreed Values
Accounts Investment Investment
by F by G
Cash P 100,000 P 100,000
Inventory 100,000 -
Land - 200,000
Building - 400,000
Equipment 200,000 _ -
Totals 400.000 P 700,000
Mortgage on building assumed by the _ - 200,000
partnership P 400,000 P 500,000

Assumption 1: Assuming that F and G agree that each partner is to

receive a capital cred equal to the agreed values of the net assets
each partner invested:
To record adjustments: nothing to adjust since both of them have
no set of books.
To close the books: nothing to close since both of them have no set
of books
To record investments - Partnership books
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
F, .capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Initial investment. 400,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Mortgage payable. . . . . . . . . . . . . . . . . . . . . . 400,000
G, .capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Initial investment. 500,000

Assumption 2: Assuming that F and G agree that each partner is to

receive an equal capital interest
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To record adjustments: nothing to adjust since both of them have
no set of books.
To close the books: nothing to close since both of them have no set
of books.
To record investments: Partnership books:
Bonus Approach:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
F, .capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Mortgage payable. . . . . . . . . . . . . . . . . . . . . . 200,000
G, .capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Initial investment.

G, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
F, Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Bonus to F

Total agreed capital (P400.000+ P500,000) P 900.000

Multiplied by: Capital interest (equal) _ ½
Partner's individual capital interest... P 450,000
Less: F's capital interest 400,000
Bonus to F P 50,000
Note: Under the bonus method, there is a capital interest transfer of P50.000
from G to F to equalize the capital balances. Such an entry is made if Partner G
recognizes that Fis contributing something to the firm other than the tangible
assets, but the partners are reluctant to recognize an intangible asset, or a value
for it cannot be determined objectively.
Revaluation (Goodwill) Approach:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
F, .capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

15
 Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Mortgage payable. . . . . . . . . . . . . . . . . . . . . . 200,000
G, .capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Initial investment.

Assets (or goodwill or intangible asset) . . . 50,000

F, Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Bonus to F

Total agreed capital (P500,000 / ½ ) P 1,000.000

Less: Total contributed capital
(P400.000+ P500,000) 900,000
Assets (or goodwill or intangible asset) P 50,000
Note: Under the revaluation (goodwill approach, if equal capital interests were
to be given to each partner F's capital is increased by P100.000. This is
accomplished by recognizing an intangible asset of P100,000 It should be noted
that the capital of G was used as a basis to determine the total agreed capital
instead of the capital of F which may not give rise to a positive revaluation of
asset (goodwill). It is therefore assumed that F is contributing something of
value to the partnership that is intangible in nature, and which could not be
specifically identified. Unless the intangible is specifically identifiable, such as a
patent, it should not be probably recognized.
Bonus or Revaluation Approach on Initial Investments. A
valuation problem arises when partners agree on relative capital
interests that are not aligned with their investments of identifiable
assets. Both approaches are equally tolerable in aligning the
capital accounts with the agreement and are equitable in assigning
capital interests to individual partners. A decision to use one
approach over the other will depend on partners' agreement toward
recording the P100,000 adjustments in assets under the revaluation
approach and P50,000 under the bonus approach.
If there is no specification as to what approach may be used, the
bonus approach would be preferred (refer to Chapter 21 on the
justification of the usage of bonus approach over the revaluation
approach.) Also, refer to Chapter 21 regarding goodwill in cases of
admission of a partner.

Illustration 7-1: Individual vs. Sole Proprietor

Below is the balance sheet of H on November 30, 20x4 before
accepting I as his partner to form HI Partnership:

16
 H Partnership
Balance Sheet
November 30, 20x4
Assets
Cash P 100,000
Accounts receivable P 40,000
Less: Allowance for doubtful accounts 2,500 37,500
Notes receivable 50,000
Merchandise inventory 22,500
Equipment P 60,000
Less: Accumulated depreciation 5,000 55,000
Total assets P 265,000
Liabilities and Capital
Accounts payable P 10,000
Notes payable 50,000
H. capital P 205,000
Total abilities and capital

It is agreed that for purposes of establishing H's interest the

following adjustments shall be made:
a. The accounts receivable is estimated to be 90% realizable.
b. Interest at 8% on notes receivable dated March 1, 20x4 is to be
accrued.
c. The merchandise inventory is to be valued at P17,500.
d. The equipment is under-depreciated by P4,000.
e. Prepaid expenses of P2,000 and accrued expenses of P6,000 are
to be recognized.
I is to invest cash to obtain a one-third interest in the partnership.
Assumption 1: Old set of books. Assuming the books of H is to be
retained by the new partnership; the following procedures are to
be followed:
Books of Sole Proprietor (H):
To record adjustments:

a. H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Allowance for doubtful accounts . . . . . 1,500
Additional provision
Required allowance: 10% x 40,000 . . P 4,000
Less: Previous balance . . . . . . . . . . . . . . . 2,500
Additional provision. . . . . . . . . . . . . . . . . 1,500

17
 b. Interest receivable . . . . . . . . . . . . . . . . . . . . . 3,000
H, capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Interest income for 9 months
P50,00 x 8% x 9/12 = P3,000

c. H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Merchandise inventory . . . . . . . . . . . . . . . 5,000
Decline in the value of merchandise
P22,500 – 17,500 = P5,000

d. H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Accumulated depreciation . . . . . . . . . . . . 4,000
Under depreciation

e. Prepaid expense . . . . . . . . . . . . . . . . . . . . . . . 2,000

H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Expenses paid in advance

H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Accrued expenses . . . . . . . . . . . . . . . . . . . . 6,000
Unrecorded expenses

Note: All adjustment that reflect nominal accounts should be coursed through
the capitol account, because all nominal accounts are already closed at the time
of formation.
To close the books: nothing to close since the books of H will be
retained.
To record Investment:

a. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
I, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,750
Additional provision 96,750
Unadjusted capital of H... P 205,000
Add (deduct): adjustments:
a. Doubtful accounts (1,500)
b. Interest income 3,000
c. Decline in the value of merchandise (5,000)
d. Under-depreciation. (4,000)
e. Prepaid expenses.. 2,000
Accrued expenses. (6,000)
Adjusted capital balance of H
P
Divided by: Capital interest of H.
193,500
Total agreed capital
_ 2/3
Multiplied by: Capital interest of I.
Investment of I P 290,250
_ 1/3
18
 P 96,750
Note: The initial investment of H is already recorded in as much as his books are
already retained. No further entry is required because there are no additional
investments or withdrawals made by H.

Assumption 2: New set of books. The following procedures are to

be followed:
Books of Sole Proprietor (H):
To record adjustments:

a. H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Allowance for doubtful accounts . . . . . 1,500
Additional provision

b. Interest receivable . . . . . . . . . . . . . . . . . . . . .
H, capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
3,000
Interest income for 9 months

c. H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Merchandise inventory . . . . . . . . . . . . . . . 5,000
Decline in the value of merchandise

d. H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Accumulated depreciation . . . . . . . . . . . . 4,000
Under depreciation

e. Prepaid expense . . . . . . . . . . . . . . . . . . . . . . . 2,000

H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Expenses paid in advance
6,000
H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6,000
Accrued expenses . . . . . . . . . . . . . . . . . . . .
Unrecorded expenses

Note: All adjustment that reflect nominal accounts should be coursed through
the capitol account, because all nominal accounts are already closed at the time
of formation.
To close the books:

Allowance for doubtful accounts . . . . . . . . . . 4,000

Accumulated depreciation . . . . . . . . . . . . . . . . 9,000
19
 Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Notes receivable . . . . . . . . . . . . . . . . . . . . . 40,000
Interest receivable . . . . . . . . . . . . . . . . . . . 3,000
Accounts receivable . . . . . . . . . . . . . . . . . . 50,000
Merchandise inventory . . . . . . . . . . . . . . . 17,500
Prepaid expenses . . . . . . . . . . . . . . . . . . . . 2,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Closing of real accounts

New Set of Books (Partnership Books)

To record investment
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . 3,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . 50,000
Merchandise inventory . . . . . . . . . . . . . . . . . . . 17,500
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
4,000
Allowance for doubtful accounts . . . . . .
9,000
Accumulated depreciation . . . . . . . . . . . .
6,000
Accrued expenses . . . . . . . . . . . . . . . . . . . .
10,000
Accounts payable . . . . . . . . . . . . . . . . . . . . .
50,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . .
193,500
H, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
96,750
I, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
96,750
Initial investment
Note:
1. No further entries are required because there are no additional investments
or withdrawals made by H
2. I should be recognized that accumulated depreciation is not carried
forward to the newly formed partnership in the same fashion with business
combination. The reason is that the net amount will be depreciated based
on the remaining or revised life of the depreciable asset.
The balance sheet for both cases presented above is as follows:
HI Partnership

20
 Balance Sheet
November 30,20x4
Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 196,750
. P 40,000
Accounts 4,000 36,000
receivable . . . . . . . . . . . . . . . . . . . . . . . 50,000
Less: Allowance for doubtful 3,000
accounts . . . . . 17,500
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . P 60,000
Merchandise inventory . . . . . . . . . . . . . . . . . . . 9,000 51,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . P 356,250
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Accumulated
depreciation . . . . . . . . . . .
Total
assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Capital
Liabilities
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . P 6,000
Accounts 10,000
payable . . . . . . . . . . . . . . . . . . . . . . . 50,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . P 66,000
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . .
Capital P 193,500
H. 96,750
capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 356,250
I,
capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total Liabilities and
capital . . . . . . . . . . . . . . . .

Illustration 17-3: Sole Proprietor vs. Sole Proprietor

On October 1, 20x4, J and K decided to pool their assets and form a
partnership. They allocate profit and loss in the ratio of 44:56 for
them, respectively. The firm is to take over business assets and
assume business liabilities, and capitals are to be based on net
assets transferred after the following adjustments:
a. J's inventory amounting to P10.000 is worthless, while K's agreed
value of inventory amounted to P125,000.
b. Uncollectible accounts of P6,000 for J is to be provided; a 5%
allowance is to be recognized in the books of K..

21
c. Accrued rent income of P10,000 on J, and accrued salaries of
P8,000 on K should be recognized on their respective books.
d. Interest at 16% on Notes Receivable dated August 17, 20x4
should be accrued.
e. The office supplies unused amounted to P20,000.
f. The equipment's agreed value amounted to P50,000.
g. The furniture and fixtures has a fair market value of P90,000.
h. Interest at 12% on Notes Payable dated July 1, 20x4 should be
accrued. Use 360 days a year.
i. K has an unrecorded patent amounting to P40,000 and is to invest
the additional cash necessary to have a 60% interest in the new
firm

Balance sheets for J and Kon October 1, 20x4 before adjustments are
given below:
Accounts J K
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 75,000 P 45,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . 180,000 150,000
Allowance for doubtful accounts . . . . . . . . . . (4,000) (5,000)
Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Merchandise Inventory . . . . . . . . . . . . . . . . . . . . 160,000 120,000
Office Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Accum. depreciation – equipment . . . . . . . . . (45,000)
Furniture and Fixtures . . . . . . . . . . . . . . . . . . . . 120,000
Accum. depreciation - furniture & fixtures . _ _ (20,000)
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 493,000 P 460,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . P 133,000 P 100,000

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 -0-
Capitals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310,000 360,000
Total Liabilities and Capital . . . . . . . . . . . . . . . . P 493,000 P 460,000

Assumption 1: Old set of books. Assuming the books of K is to be

retained by the new partner; the following procedures are to be
followed:
Books of Sole Proprietor
To record adjustments:
Books of J Books of K
J, capital 10,000 Merchandise inventory 5,000
Merchandise inventory 10,000 K, capital 5,000
Worthless inventory Upward revaluation
J, capital 6,000 K, capital 2,500

22
 Allowance for doubtful 6,000 Allowance for doubtful a 2,500
a. Additional provision
Additional provision Required allowance:
5% x 150,000 . . . . . . . . . . . 7,500
Less: Previous balance . . 5,000
Additional provision . . . . 2,500
Rent receivable 10,000 K, capital 8,000
J, capital 10,000 Salaries payable 8,000
Income earned Unpaid salaries
J, capital 7,000 Interest receivable 1,000
Office supplies 7,000 K, capital 1,000
Expired office supplies Interest income (8/17 – 10/1)
P50,000 x 16% x 45/360
J, capital 5,000 K, capital 10,000
Accum. depre – equipm. 5,000 Acumm depre. – fur & fix 10,000
Under-depreciated Under-depreciated
J, capital 1,500 Patent 40,000
Interest payable 1,500 K, capital 40,000
Interest expense (7/1 – 10/1) Unrecorded patent
50,000 x 12% x 3/12

Unadjusted capital of J P310,000 Unadjusted capital of K P360,000

Add(deduct):adjustments Add(deduct):adjustments
Worthless merchandise (10,000) Merchandise revaluation 5,000
Doubtful accounts (6,000) Doubtful accounts (2,500)
Rent income 10,000 Salaries expense (8,000)
Office supplies expense (7,000) Interest income 1,000
Additional depreciation (5,000) Additional depreciation (10,000)
Interest expense (1,500) Patent 40,000
Adjusted capital of J P290,500 Adjusted capital of K P385,500

To close the books:

Books Books of J
of K
N/A Allowance for doubtful accounts . . . 10,000
Accum. depreciation – equipment . . 50,000
Accounts payable . . . . . . . . . . . . . . . . . . 133,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . 50,000
Interest payable . . . . . . . . . . . . . . . . . . . . 1,500
J, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . 290,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000
Accounts Receivable . . . . . . . . . . . . 180,000
Merchandise Inventory . . . . . . . . . 150,000
Office Supplies . . . . . . . . . . . . . . . . . . 20,000
Equipment . . . . . . . . . . . . . . . . . . . . . . 100,000
Rent receivable . . . . . . . . . . . . . . . . . 10,000

Books of K – To record investments:

Books of K Books
23
 of J
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 N/A
Accounts Receivable . . . . . . . . . . . . . . . 180,000
Merchandise Inventory . . . . . . . . . . . . 150,000
Office Supplies . . . . . . . . . . . . . . . . . . . . . 20,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . 100,000
Rent receivable . . . . . . . . . . . . . . . . . . . 10,000
Allowance for doubtful accounts 10,000
Accum.depreciation – equipment 50,000
Accounts payable . . . . . . . . . . . . . . . 133,000
Notes payable . . . . . . . . . . . . . . . . . . . 50,000
Interest payable . . . . . . . . . . . . . . . . . 1,500
J, capital . . . . . . . . . . . . . . . . . . . . . . . . 290,500

The following observations should be noted

1. Accounts receivable is normally recorded at gross amount less
allowance. The mason for such practice is that the new
partnership seldom changes the percent of doubtful accounts.
usually they based it on the original estimate wherein the gross
amount is the basis,
2. Assets that are based on depreciation (and amortization) is
recorded at net amount because the life of such assets are usually
revised by the new partnership. The estimated life of such assets
may change overtime because they are based either on functional
or physical factors.

Assumption 2: New set of books. The following procedures are to

be followed:
Books of Sole Proprietor
To record adjustments:
Books of J Books of K
J, capital 10,000 Merchandise inventory 5,000
Merchandise inventory 10,000 K, capital 5,000
Worthless inventory Upward revaluation
J, capital 6,000 K, capital 2,500
Allowance for doubtful 6,000 Allowance for doubtful a 2,500
a. Additional provision
Additional provision Required allowance:
5% x 150,000 . . . . . . . . . . . 7,500
Less: Previous balance . . 5,000
Additional provision .. . . 2,500
.
Rent receivable 10,000 K, capital 8,000
J, capital 10,000 Salaries payable 8,000

24
Income earned Unpaid salaries
J, capital 7,000 Interest receivable 1,000
Office supplies 7,000 K, capital 1,000
Expired office supplies Interest income (8/17 – 10/1)
P50,000 x 16% x 45/360
J, capital 5,000 K, capital 10,000
Accum. depre – equipm. 5,000 Accum depre. – fur & fix 10,000
Under-depreciated Under-depreciated
J, capital 1,500 Patent 40,000
Interest payable 1,500 K, capital 40,000
Interest expense (7/1 – 10/1) Unrecorded patent
50,000 x 12% x 3/12

Unadjusted capital of J P310,000 Unadjusted capital of K P360,000

Add(deduct):adjustments Add(deduct):adjustments
Worthless merchandise (10,000) Merchandise revaluation 5,000
Doubtful accounts (6,000) Doubtful accounts (2,500)
Rent income 10,000 Salaries expense (8,000)
Office supplies expense (7,000) Interest income 1,000
Additional depreciation (5,000) Additional depreciation (10,000)
Interest expense (1,500) Patent 40,000
Adjusted capital of J P290,500 Adjusted capital of K P385,500

Books of J Books of K
Allowance for doubtful a. 10,000 Allowance for doubtful a.
Accum. depre. – euipm. 50,000 Accum. depre. – fur & fix 7,500
Accounts payable 133,000 Accounts payable 30,000
Notes payable 50,000 Salaries payable 100,000
Interest payable 1,500 K, capital 8,000
J, capital 290,500 Cash 385,500
Cash 75,000 Accounts Receivable 45,000
Accounts Receivable 180,00 Notes receivable 150,000
Merchandise inventory 0 Interest receivable 50,000
Office Supplies 150,00 Merchandise inventory 1,000
Equipment 0 Furniture and fixture 125,000
Rent receivable 20,000 Patent 120,000
100,00 40,000
0
10,000

New Set of Books

To record the investments
Books of J
Cash 75,000
Accounts Receivable 180,000
Merchandise inventory 150,000
Office Supplies 20,000
Equipment 100,000
Rent receivable 10,000
Allowance for doubtful accounts 10,000
Accumulated depreciation - equipment 50,000
25
 Accounts payable 133,000
Notes payable 50,000
Interest payable 1,500
J, capital 290,500

Cash 45,000
Accounts Receivable 150,000
Notes receivable 50,000
Interest receivable 1,000
Merchandise inventory 125,000
Furniture and fixture 120,000
Patent 40,000
Allowance for doubtful accounts 7,500
Accumulated depreciation – furniture and fixture 30,000
Accounts payable 100,000
Salaries payable 8,000
K, capital 385,500

The balance sheet after formation is as follows:

J and K Partnership
Balance Sheet
October 1,20x4
Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 120,000
. P 330,000
Accounts 17,500 312,500
receivable . . . . . . . . . . . . . . . . . . . . . . . 50,000
Less: Allowance for doubtful 1,000
accounts . . . . . 10,000
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 275,000
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Rent receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Merchandise inventory . . . . . . . . . . . . . . . . . . . 90,000
Office 40,000
supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 968,500
Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . .
Furniture and fixture
(net) . . . . . . . . . . . . . . . .
Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total
assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Capital
Liabilities
Salaries P 8,000
payable . . . . . . . . . . . . . . . . . . . . . . . . 133,000
Accounts 50,000
26
 payable . . . . . . . . . . . . . . . . . . . . . . . 1,500
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . P 192,500
Interest
payable . . . . . . . . . . . . . . . . . . . . . . . . P 390,500
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 385,500
Capital P 776,000
J. capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 968,500
K,
capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total Liabilities and
capital . . . . . . . . . . . . . . . .

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