Review on Partnership

Marilou Pacho-Garcia, CPA, MBA

 Partnership Formation

Marilou Pacho-Garcia, CPA, MBA

 3

Partnerships: Organization

Partnerships
and Operation

Is an association of two or more persons who

contributed money, property, or industry to a common
fund with the intention of dividing the profit among
themselves. It’s an association of two or more
persons to carry on, as co-owners, a business for
profit".
Partnerships generally are associated with the
practice of law, medicine, public accounting and
other professions, and also with small business
enterprises.
 4

Partnerships: Organization
and Operation

Reason for forming Partnership

• It permits pooling of capital and other resources
without the complexities and formalities of a
corporation.
• It is easier to form and less costly to establish
• Generally not subject to much governmental
regulation
• Partners can operate with more flexibility because
they are not subject to the control of a board of
directors.
 5

Partnerships: Organization
and Operation

Types of Partnerships
General partnership: in which all partners have
unlimited personal liability for debts of the
partnership. Each partner is personally liable to the
partnership’s creditors.
Limited liability partnerships (LLPs): partner’s
obligations to creditors are limited to their capital
contributions. individual partners of LLPs are
personally responsible for their own actions and for
the actions of employees under their supervision.
Under LLP only one partner needs to be a general
partner.
 6

Partnerships: Organization
and Operation

Partnerships (contd.)
The LLPs as a whole, like a general
partnership, is responsible for the actions of
all partners and employees.
Since the LLPs are the prevalent form of
partnerships and the issues of organization,
income-sharing plans and changes in
ownership of LLPs are similar to those of
general partnerships, LLPs are discussed in
this chapter.
 7

Partnerships: Organization
and Operation

Features of General Partnership

• Ease in Formation
• Limited Life
• Assignment of Partner’s Interest
• Unlimited Liability
• Mutual Agency
• Separate Legal Personality
• Sharing Profits and Losses
 8

Partnerships: Organization
and Operation

Underlying Equity Theories

• Proprietary Theory: viewed through the eyes of owner
▫ Looks at the entity through the eyes of the owner
▫ Views assets as belonging to the proprietor.
▫ Liabilities of a business are debts of the proprietor.
▫ Profits generated are viewed as increase in the proprietor’s
capital.
Characteristics of this theory:
a. Salaries to partners are considered as distribution of
income rather than as determinant of 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.
 9

Partnerships: Organization
and Operation

Underlying Equity Theories

• Entity Theory: viewed as separate & distinct entity
and exists apart from individual partners.
▫ Profits earned are viewed as profit of the entity
▫ Each partner is entitled to a distributive share in profit
▫ Legal life transcends the death or admission of a partner
 10

Partnerships: Organization

Articles of Partnership
and Operation

• Name of the partnership

• The name, addresses of the partners, classes of
partners, stating whether the partners are general or
limited
• The effective date of the contract
• The purpose/s & principal office of business
• The capital of the partnership, stating the
contribution of individual of partners, their
description and agreed values
• The rights & duties of each partner
 11

Partnerships: Organization

Articles of Partnership (cont..)

and Operation

• The manner of dividing net income or loss among the

partners including salary allowance & interest on
capital
• The conditions under which the partners withdraw
money or other assets for partnership use
• The manner of keeping the book of accounts
• The causes of dissolution
• The provision fro arbitration in settling disputes
 12

Partnerships: Organization

Organization of a Limited Liability

and Operation

Partnership (LLP)
 Basic Characteristics of the LLP:
1. Ease of Formation.
2. Limited Life.
3. Mutual Agency.
4. Co-Ownership of Partnership Assets and
Earnings.
 13

Partnerships: Organization
and Operation

Accounting for Partnership Activities

• Capital Account
▫ increased by investment at FMV at the time of investment
& share in profit of net income
▫ decreased by withdrawal of cash or other assets & share in
net loss
• Drawing Account
▫ Non cash drawings should be valued at FMV at the time of
withdrawal.
▫ Close to capital account at the end of accounting period
before a balance sheet is prepared
 14

Partnerships: Organization
and Operation

Accounting for Partnership Activities

• Classes of withdrawals
▫ Capital withdrawal or permanent withdrawal:
 Withdrawals of investment (original or additional)
 Directly affects the capital account balances
• Personal withdrawal or temporary withdrawal:
• Initially recorded in drawing account
• Drawings from share of profits
• Eventually closed to capital account
• Loan Accounts (advances to or from)
• A partner receive cash from partnership with the intention
of repaying the amount. Can be interest-bearing
depending on agreement
• A partner may make cash payment to the partnership that
is considered as loan rather than an increase in the
partner’s capital account balance
 15

Partnerships: Organization
and Operation

Valuation: Investment to Partnership

1. Cash Investments
• Cash investment – recorded at fair value or at face
value which is the amount payable on demand or to
be collected as at balance sheet date.
• Foreign currency denominated cash –valued at
current exchange rate.
• Cash in bank under receivership should be shown at
its estimated recoverable amount.
 16

Partnerships: Organization
and Operation

Valuation: Investment to Partnership

2. Non Cash Investments
• Non cash property is recorded at agreed value which
normally is the fair market value.
• FMV should be determined by independent appraiser,
but for practicability value is by agreement of
partners.
• In case there is conflict between agreed value and fair
value, the agreed value prevails.
3. Services Investment
• A memorandum entry is essential if no agreed value,
otherwise a journal entry is required.
 17

Partnerships: Organization
and Operation

Valuation: Investment to Partnership

4. Liabilities Assumed by partnership should be valued at
the present value (fair value) of the remaining cash
flows.
5. Percentage of Equity that each partner will have should
be agreed upon, which is generally based on capital
balances.

The partnership must clearly distinguish between capital

contribution and loans made to the partnership. Loan
arrangements should be evidence by a promissory notes
or other legal documents necessary to show that a loan
arrangement exists between the partnership and an
individual partner.
 18

Partnerships: Organization
and Operation

Forming a Partnership
• For the first time
• Conversion of sole proprietor to partnership
• Conversion of old partnership to new
partnership
• Admission of new partner
 19

Partnerships: Organization
and Operation

Bonus or Goodwill Method

Methods used to address valuation problem where
partners agree on capital interest that do not equal to
the assets invested.
• Bonus method recognizes only the assets that are
physically contributed to the business.
• Goodwill method is based on the assumption that an
implied value can be estimated mathematically and
recorded for as intangible contribution made by a
partner.
• Solve Prob1 page 20 (individuals forming)
 PARTNERSHIP OPERATION

Dividing Profit & Loss

Marilou Pacho-Garcia, CPA, MBA

DIVIDING NET INCOME OR NET LOSS

• Partnership net income or net loss is shared equally

unless the partnership contract indicates otherwise.
• The same basis of division usually applies to both net
income and net loss, and is called the income ratio, or the
profit and loss ratio.
• A partner’s share of net income or net loss is recognized
in the accounts through closing entries.
 CLOSING ENTRIES
The following 4 closing entries are required for a partnership:

1) Debit each revenue account for its balance and credit Income
Summary for total revenues.
2) Debit Income Summary for total expenses and credit each expense
account for its balance.
3) Debit (credit) Income Summary for its balance and credit (debit)
each partner’s capital account for his or her share of net income (net
loss).
4) Debit each partner’s capital account for the balance in that
partner's drawing account and each partner’s drawing account for the
same amount.
 CLOSING ENTRIES
The first 2 entries are the same as a proprietorship, while
the last 2 entries are different because:
1) there are 2 or more owners’ capital and drawing
accounts
2) it is necessary to divide net income or loss among the
partners.
 Illustration: CLOSING NET INCOME AND
DRAWING ACCOUNTS
The AB Company has net income of P32,000 for 2014. The partners, A. Arbor and
B. Barnett, share net income and net loss equally, and drawings for the year were
Arbor P8,000 and Barnett P6,000. The last two closing entries are:

Date Account Titles and Explanation Debit Credit

Dec. 31 Income Summary

L. Arbor, Capital (P32,000 X 50%)
D. Barnett, Capital (P32,000 X 50%)
(To transfer net income to owners’
capital accounts)

32,000
31 L. Arbor, Capital
D. Barnett, Capital
L. Arbor, Drawing
D. Barnett, Drawing
(To close drawing accounts to
capital accounts)
16,000
16,000

8,000
6,000
8,000
6,000
 Illustration: PARTNERS’ CAPITAL AND DRAWING
ACCOUNTS AFTER CLOSING

Assuming the beginning capital balance is P47,000 for Arbor and

P36,000 L. Arbor, Capital
12/31 Closing 8,000 1/1 Balance 47,000
for Barnett, the 12/31 Closing 16,000
12/31 Balance 55,000
capital and drawing
accounts will show the L. Arbor, Drawing

following after posting 12/31 Balance 8,000 12/31 Closing 8,000

D. Barnett, Capital
the closing entries: 12/31 Closing 6,000 1/1 Balance 36,000
12/31 Closing 16,000
12/31 Balance 46,000

D. Barnett, Drawing
12/31 Balance 6,000 12/31 Closing 6,000
 INCOME RATIOS
The partnership agreement should specify the basis for sharing net
income or net loss. The following are typical income ratios:
1. A fixed ratio, expressed as a proportion (6:4), a percentage (60%
and 40%), or a fraction (3/5 and 2/5).
2. A ratio based on either capital balances at the beginning of the
year or on average capital balances during the year.
3. Salaries to partners and the remainder on a fixed ratio.
4. Interest on partners’ capital balances and the remainder on a
fixed ratio.
5. Salaries to partners, interest on partners’ capitals, and the
remainder on a fixed ratio.
 TYPICAL INCOME-SHARING RATIOS
FIXED RATIO

If A. Hughes and D. Lane are partners, each

contributing the same amount of capital, but Hughes
expects to work full-time and Lane only part-time, a
2/3, 1/3 fixed ratio may be equitable. The entry to
close P21,000 net income to partner’s capital accounts
is:
Date Account Titles and Explanation Debit Credit

Dec. 31 Income Summary 21,000

A. Hughes, Capital (P21,000 X 2/3) 14,000
D. Lane, Capital (P21,000 X 1/3)
7,000
(To transfer net income to owners’
capital accounts)
TYPICAL INCOME-SHARING RATIOS – CAPITAL
BALANCES
• This income-sharing ratio may be based either on
capital balances at the beginning of the year or on
average capital balances during the year.

• Capital balances income-sharing may be equitable

when a manager is hired to run the business, and the
partners do not plan to take an active role in daily
operations.
 TYPICAL INCOME-SHARING RATIOS –
SALARIES
• Income-sharing based on salary allowances may be:
1) Salary allowances to partners and the remainder on a fixed
ratio or
2) Salary allowances to partners, interest on partners’ capitals,
and the remainder on a fixed ratio.
• Salaries to partners and interest on partner’s capital balances
are not expenses of the partnership; therefore, these items do
not enter into the matching of expense with revenues and the
determination of net income or net loss.
 Illustration: INCOME STATEMENT
WITH DIVISION OF NET INCOME
KINGSLEE COMPANY
Sara King and Ray Lee are Income Statement
copartners in the Kingslee For the Year Ended December 31, 2014
Company with beginning
capital balances of PP28,000 Sales P 200,000
& P24,000 repectively. The Net income P 22,000
partnership agreement
Division of Net Income
provides for:
1) salary allowances of Sara Ray
P8,400 for Sara and King Lee Total
P6,000 for Ray, Salary allowance P 8,400 P 6,000 P 14,400
Interest allowance on partner’s behalf
2) interest allowances of Sara King (P28,000 X 10%) 2,800
10% on capital balances Ray Lee (P24,000 X 10%) 2,400
at the beginning of the Total interest allowances 5,200
year, and Total salaries and interest 11,200 8,400 19,600
Remaining income – P2,400 (P22,000 – P19,600)
3) the remainder equally. Sara King (P2,400 X 50%) 1,200
The division of the 2002 Ray Lee (P2,400 X 50%) 1,200
net income of P22,000 is Total remainder 2,400
as follows: Total division P 12,400 P 9,600 P 22,000
 SALARIES, INTEREST, AND REMAINDER ON A
FIXED RATIO

Capital balances on January 1, 2014 were Sara King – P28,000 and

Ray Lee – P24,000. The entry to record the division of net income is:

Date Account Titles and Explanation Debit Credit

Dec. 31 Income Summary 22,000

Sara King, Capital 12,400
Ray Lee, Capital 9,600
(To close net income to partners’
capitals)
 Illustration: DIVISION OF NET INCOME
INCOME DEFICIENCY
Net income in Kingslee Company is assumed to be only P18,000. In this case, the salary
and interest allowances will create a P1,600 deficiency (P19,600 – P18,000). Since the
calculations of the allowances are the same as in Illustration 6, the division of net income
will begin with total salaries and interest, as shown below.

Sara Ray
King Lee Total
Total salaries and interest P 11,200 P 8,400 P 19,600
Remaining deficiency – P1,600 (P18,000 – P19,600)
Sara King (P1,600 X 50%) ( 800)
Ray Lee (P1,600 X 50%) ( 800)
Total remainder ( 1,600)
Total division P 10,400 P 7,600 P 18,000

Prob. 1, page 49
 Partnership Dissolution
Marilou Pacho-Garcia, CPA, MBA

33
Introduction
34

• A partnership may dissolve due to disagreement

among the partners, poor performance of the firm
or being taken over by another business.
• The assets of the partnership will be realized to
pay off the liabilities.
• The sales proceeds should be applied in the
following order, as required by the Hong Kong
Ordinance:
▫ Pay off creditors first,
▫ then the partners’ advances, and
▫ Finally the partners’ capital
 35

Realization Account
• In the partnership dissolution, an account named
as ‘Realization Account’ will be opened to compute
the profit or loss from realization which should be
shared among the partners according to the profit
or loss sharing ratio
 36

Nature of partnership dissolution

• Dissolution where the assets are sold separately
• Dissolution where partnership is sold as a whole
Dissolution where Assets are sold
separately

37
 38

Procedures of Dissolution
1. All assets will be sold to other persons or taken over
by partners
2. Settle the liabilities of the partnership to outsider or
partners
3. Transfer any ‘profit or loss on realization’ to each
partner’s capital accounts in profit/loss sharing ratio
4. Merge the balances in the partners’ current accounts
to their capital accounts
 39

5. Any credit balance in each partner’s capital

account represents the amount which can be
withdrawn from the partnership to each partner;
while any debit balance in a partner’s capital
account represents additional cash to be injected
by that partners
 Partnership liquidation
Lump-sum
Marilou Pacho-Garcia, CPA, MBA
Liquidation
• Liquidation of a partnership means winding up
the business usually by selling the assets, paying
the liabilities and distributing the remaining cash
to the partners.
• A business which is in the process of converting its
assets into cash and making settlement with
creditors is said to be in liquidation.
• A term which is always used by a business that is
in the process of liquidation is realization, which
means the sales of assets.
Rules: Liquidation of Partnership
• Always allocate and close gains & losses to the
partners’ capital accounts prior to distributing any
cash to the partners.
• When the business is liquidated, the partner is
entitled to an amount depending upon his capital
contribution, his drawing, his share in the net
income or loss from operations before liquidation,
gains and losses on realization , and the balance of
his loan account, if any.
General Rule: Cash Distribution
• First, to outside creditors
• Second, to partners for loan accounts –
supported by an establish legal doctrine
called right of offset.
• Third, to partners for capital accounts
▫ Debit balance in the partners’ account may be
caused by losses incurred in the realization of
assets or by pro-rata absorption of an
uncollectible deficit of a partner whose
combined capital and loan accounts is not
enough to absorb the partners’ share of total
assets.
Methods of Partnership Liquidation
• Lump-Sum Liquidation,
otherwise called Total Liquidation or
Single Distribution
• Installment Liquidation,
otherwise called installment
Distribution
Lump-Sum Liquidation
• Realization of Assets
▫ “Going Out of Business” - Will experience
losses on sale of assets
▫ Inventory is marked down well below
normal selling price to encourage
immediate sale.
▫ AR – offer large cash discount for
prompt payment or may be sold to factor
Liquidation Procedures
1. Realization of assets and distribution of
gain or loss on realization among the
partners based on the profit and loss
ratio.
2. Payment of expenses
3. Payment of liabilities
4. Elimination of partners’ capital
deficiencies
5. Payment to partners
Order of Priority
• Eliminate partners’ capital deficiency
1. If the deficient partner has a loan balance,
exercise the “right of offset”
2. If the deficient partner is solvent, make him
invest cash
3. If the deficient partner is insolvent, let the
other partners absorb his deficiency
• Payment to partners
1. Loan accounts
2. Capital accounts
Partners’ Capital Account
• Partners’ capital balances before
realization should be after closing the
following account:
▫ Partners’ drawing
▫ Partnership goodwill account
▫ Receivable from partners
▫ Payable to partners (other than loan)
Partnership liquidation
Installment
Marilou Pacho-Garcia, CPA, MBA

Liquidation - installment
Installment Liquidation
• Involves selling of some assets, paying liabilities of
partnership, dividing the available cash to the
partners, selling additional assets and making
further payments to partners.

• This process continues until all the assets have

been sold and all cash been distributed to the
creditors and to the partners.
Procedures for Installment Liquidation
1. Record the realization of assets and distribute the
realized gains or losses among the partners using the
profit and loss ratio.
2. Pay liquidation expenses and unrecorded liabilities, if
there are any, and distribute these among the partners
using the profit and loss ratio.
3. Pay the liabilities to outsiders.
4. Distribute cash to partners after possible future losses
have been apportioned to partners or in accordance
with a cash distribution program

Note: Eliminate any capital deficiency only before final

payments to partners.
Schedule of Safe Payments
• Supports the statement of liquidation and is
prepared periodically.
• Assumes that no more cash is forthcoming, either
from sale of assets or from collection of deficiencies
from partners.
• Cash is distributed to a partner:
▫ only if he has an excess credit balance in his
partnership interest (i.e. capital account and loan
accounts combined);
▫ After absorption of his share of the maximum
possible loss that may occur.
Possible Loss (hypothetical loss)
• Total value of remaining non-cash assets; these assets are
assumed unrealizable
• Cash withheld to pay for anticipated liquidation expenses
and unrecorded liabilities
• Deficiency of any partner that has to be absorb by other
partners .
Note:
At some point of liquidation, the safe payment schedule
brings the partner’s capitals to the profit and loss ratio.
Absence of partner’s capital deficiency, after distribution
of possible loss signifies that the ratio of capital balances
are in the profit and loss ratio.
Cash Withheld
• Cash withheld are cash set aside to insure payment
▫ of potential liquidation expenses which may be
incurred,
▫ Unrecorded liabilities which maybe discovered
• Cash withheld is to be added to the value of the
remaining non-cash assets to obtain the maximum
possible loss
• Cash available for distribution to the partners for the
period should be net of cash withheld.