CHAPTER 2: NATURE AND FORMATION OF A PARTNERSHIP

Partnership is defined in Article 1767 of the Civil Code of the Philippines as “a contract whereby two or
more persons binds themselves together to contribute money, property or industry to a common fund with the
intention of dividing profits among themselves.”

CHARACTERISTICS OF A PARTNERSHIP
1. Mutual Agency – any partner may act as agent of the partnership in conducting its affairs
2. Unlimited Liability – the personal assets (assets not contributed to the partnership) of any partner may
be used to satisfy the partnership creditors’ claims upon liquidation, if partnership asset are not enough
to settle the liabilities to outsiders.
3. Limited life – a partnership may dissolve at any time by action of the partners or operation of law.
4. Legal entity – a partnership has legal personality separate and distinct from that of each of the partners
5. Co-ownership of contributed assets – Property contributed to the partnership are owned by the
partnership by virtue of its separate legal personality
6. Income tax – partnership, except general professional partnerships (i.e., those organized for the exercise
of professions like CPAs, lawyers, engineer, etc.) are subject to the 30% income tax.

ADVANTAGES OF PARTNERSHIP DISADVANTAGE OF PARTNERSHIP

1. It is easy and inexpensive to organize, as it is
formed by a simple contract between two or
more persons.
2. The unlimited liability of the partners makes it
reliable from the point of view of the creditors.
3. The combined personal credit of the partners
offers better opportunity for obtaining
additional capital than does a sole
proprietorship.
4. The participation in the business by more than
one person makes it possible for a closer
supervision of all the partnership activities.
5. The direct gain to the partners is an incentive
to give close attention to the business.
6. The personal element in the characters of the
partners is retained.
1. The personal liability of a partner for from
deters many from investing capital in a
partnership.
2. A partner may be subject to personal liability
for the wrongful acts or omissions of his/her
associates.
3. It is less stable because it can easily be
dissolved.
4. There is divided authority among the partners.
5. There is constant likelihood of dissension and
disagreement when each of the partners has the
same authority in the management of the firm.

KINDS OF PARTNERSHIPS
1. As to Activity
a. Trading partnership – one whose main activity is the manufacture and sale or the purchase
and sale of goods,
b. Non-trading partnership – one which is organized for the purposed of rendering services.

2. As to Object
a. Universal partnership
i. Universal partnership of all present property – All assets contributed to the
partnership and subsequent acquisitions become common partnership assets
ii. Universal partnership of all profit – Partnership assets consist of assets acquired during
the life of the partnership and only the usufruct or use of assets contributed at the time of
partnership formation. The original movable or immovable property contributed do not
become common partnership assets.
b. Particular partnership – one which has for its object determinate things, their use or fruits or a
specific undertaking or the exercise of a profession or vocation.
 3. As to liability of partners
a. General co-partnership – one consisting of general partners who are liable prorate and
sometimes solidarity with their separate property for partnership liabilities.
b. Limited liabilities – one formed by two or more persons having as members one or more
general partners and one or more limited partner, who as such are not bound by the obligations of
the partnership
- The word “LIMITED” or “LTD” is added to the name of partnership[ to inform
the public that it is limited partnership

4. As to duration
a. Partnership at will – no term is specified and is not formed for a particular undertaking or
venture and which may be terminated any time by mutual agreement of the partners or the will of
one partner alone.
b. Partnership with a fixed term – the term or period for which the partnership is agreed upon.

5. As to representation to others
a. Ordinary partnership – actually exists among the partners and also as to third persons
b. Partnership by estoppel – one which in reality is not a partnership but is considered as one only
in relation to those who, by their conduct or omission are precluded to deny or disprove the
partnership’s existence.

6. As to legality of existence
a. De jure partnership – one which complied with all the requirements for its establishment.
b. De facto partnership – one which failed to complied with one or more of the legal requirements
for its establishment.

7. As to publicity
a. Secret partnership – the existence of certain persons as partners is not made known to the
public by any of the partners.
b. Open partnership – the existence of certain persons as partners is made known to the public by
the members of the firm.

CLASSES OF PARTNERS

1. As to contribution
a. Capitalist partner – one who contributes capital in cash or property
b. Industrial partner – one who contributes industry, labor, skill, talent or service.
c. Capitalist-industrial partner – one who contributes cash, property and industry

2. As to liability
a. General partner – one whose liability to third persons extends to his separate (private) property
b. Limited partner – one which liability to third persons is limited only to the extent of his capital
contribution to the partnership.

3. As to management
a. Managing partner – one who manages actively the business of the partnership.
b. Silent partner – one who does not participate in the management of the partnership affairs.

4. Other classifications
a. Liquidating partner – one who takes charge of the winding up of partnership affairs upon
dissolution
 b. Nominal partner – one who is not really a partner, not being a party to the partnership
agreement, but is made liable as a partner for the protection of innocent third persons
c. Ostensible prater – one who takes active part in the management of the firm and is known to
the public as a partner in the business
d. Secret partner – one who takes active part in the management of the business but whose
connection with the partnership is concealed or unknown to the public
e. Dormant partner – one who does not take active part in the management of the business and is
not known to the public as a partner; he is both silent and a secret partner

Partnership Contract – a partnership is created by an oral or a written agreement. Since partnership are
required to be registered with the Office if the Securities and Exchange Commissions, it is necessary that the
agreement be in writing. The written agreement between or among the partners governing the formation,
operation and dissolution of the partnership is referred to as the Articles of Co-Partnership.

The Articles of Co-partnership contains the following information:

The name of the partnership, the names and addresses of the partners, classes of partners, stating
whether the partner is general or a limited partner; the effective of the contract; the purpose/s and principal
office of the business; the capital of the partnership stating the contributions of individual partners, their
description and agreed values; the rights and duties of each partner; the manner of dividing net income or loss
among the partners, including salary allowance and interest on capital; the conditions under which the partners
may withdraw money or other assets for personal use; the manner of keeping the books of accounts; the causes
of dissolution; and the provision for arbitration in settling disputes.

ACCOUNTING FOR PARTNERSHIPS

Plurality of Capital and Drawings Accounts – in a partnership, there should be as many capital accounts and
as many drawing accounts as there are partners (one capital account and one drawing account is maintained for
each partner).

CAPITAL ACCOUNT
1. Permanent withdrawal (decrease) of capital 1. Original investment by a partner
2. Share in partnership loss from operations 2. Additional investment by a partner
3. Debit balance of drawing account closed to 3. Share in partnership profits from operations to
capital be added to capital

DRAWING ACCOUNT
1. Personal withdrawal by a partner 1. Share in partnership profits from operation
2. Share in partnership loss from operations (this (this may be credited directly to the partner’s
may be debited directly to the partner’s capital capital account)
account)

OPENING ENTRIES
Partners may contribute cash, property or industry to the partnership. If the asset contributed is in the form of
cash, it is recorded on the partnership book at face value; if the asset contributed is in the form of property or
non-cash asset, it is recorded at agreed value, or in the absence of the agreement, at fair market value. When
industry is contributed into the partnership, a memorandum entry is prepared.

PARTNERSHIP FORMATION
Accounting entries to record the formation will depend upon how the partnership is formed. A
partnership may be formed in several ways, namely:

1. Formation of a partnership for the first time

 Cash Investment – initial cash investments in a partnership are recorded in the capital accounts
maintained for each partner.
For example, Abd and Besa each invest P100,000 cash in a new partnership. The entry to record the
investments would be:
Cash 200,000
Abad, capital 100,000
Besa, capital 100,000

Noncash Investments – the noncash asset is recorded at the current fair value of the property at the time
of investment.

Pedro Jose
(Fair value) (Fair value)
Cash P50,000
Merchandise inventory (cost P10,000) P20,000
Computer equipment (cost P50,000) 30,000
Total P50,000 P50,000

Cash 50,000
Pedro, capital 50,000
To record initial investment of Pedro

Merchandize inventory 20,000

Computer equipment 30,000
Jose, capital 50,000
To record initial investments of Jose at their fair values

2. Conversion of a sole proprietorship to a partnership

a. A sole proprietor allow another individual, who has no business of his own to join in his
business – usually, one of the perspective partners is already engaged in business prior to the
formation of the partnership. In such a case, the partner may transfer his/her assets and liabilities
(net assets) to the partnership at agreed values or at fair market values if there are no agreed
values.
- The partnership may either: (1) use the books of the sole proprietor, or (2) open a new
set of books
- It is a common practice that a new set of books are opened for any new business
marketing

Assumption 1: the partnership will use the books of the sole proprietor
The following procedures should be followed in accounting for this type of information:
1. Adjust the books of the sole proprietor to bring the balances to agreed values.
2. Record the investment of the other partner.

The following rules will be helpful in making the necessary adjusting entries:
Debit asset and credit capital for increases in asset values
Debit capital and credit asset for decreases in asset values
Debit capital and credit liabilities for increases in liability balances
Debit liabilities and credit capital for decreases in liability balances

In the case of contra asset accounts, the following ruler shall apply:
Debit contra asset account and credit capital for increases in asset values
 Debit capital and credit contra asset account for decreases in asset values

Assumption 2: The partnership will open a new set of books

b. Two or more sole proprietors form a partnership

Assumption 1: the partnership will use the books of the sole proprietor
The following procedures should be followed in accounting for this type of information:
1. Adjust the books of the sole proprietor to bring the balances to agreed values.
2. Record the investment of the other partner.

Assumption 2: The partnership will open a new set of books

3. Admission of a new partner (other chapter)

**NOTE: READ YOUR TEXTBOOK FOR BETTER UNDERSTANDING FOR THIS TOPIC
(PARTNERSHIP FORMATION) SINCE YOUR TEXTBOOK WILL PROVIDE AN ILLUTRATIVE
PROBLEM. 

Goodwill Resulting from the Acquisition of a Sole Proprietorship by a Partnership

The acquisition of a sole proprietorship/s by a partnership or formation of a partnership by a sole
proprietorship and an individual or among two or more sole proprietorships may involve the recognition of
goodwill. The goodwill shall be result of the acquisition by the new partnership of the net assets of the sole
proprietorship/s. when the capital credit exceeds the agreed value or fair value of the nest assets acquired by the
new partnership from the sole proprietorship, the excess is treated as goodwill. The adjustment for the goodwill
increases the capital of the sole proprietor.

PFRS 3 does not allow the amortization of goodwill acquired in combination and instead requires the goodwill
to be tested for impairment annually or frequently, if events or changes in circumstances indicate that the asset
might be impaired.

CAPITAL SHARE DIFFERENT FROM CAPITAL CONTRIBUTION

The individual partners must first not only on the valuation of the net asset contributions but also on
their capital share.
The capital share of each partner is the percentage of equity that each of them will have in the net assets
of the newly formed partnership.
Generally, the capital share of a partner is proportionate to his/her capital contribution.

Illustrative Problem: Alfonso and Afable formed a partnership by contributing P500,000 and
P600,000, respectively. Journal entries to record the investment of the partners under two approaches are
as follows:

1. Full investment approach

Cash 1,100,000
Alfonso, Capital 500,000
Afable, Capital 600,000

Assuming the partners agreed ti have equal capital in partnership, it is presumed that [art of the
contribution of Afable is give as bonus to Alfonso in exchange for the intangible advantage that Alfonso will be
bringing to the partnership
 2. Bonus approach
Cash 1,100,000
Alfonso, Capital 550,000
Afable, Capital 550,000
(500,000 + 600,000)/2 = 550,000

LOAN RECEIVABLE AND LOAN PAYABLE

Loan Payable or Due to Partners
– Loans made by partners to the partnership, which are payable immediately by the partnership and are
usually with interest
Loan Receivable or Due from Partners
– The partnership may advance money to partner, other than withdrawals, in the form of loans. These
loans are payable immediately by the partners and are usually with interest.