Part 2

PARTNERSHIP FORMATION

Objectives:
1. Describe the three methods of forming a partnership;
2. Discuss the nature of partnership formation; and
3. Identify the valuation of partners’ investment.

NATURE AND CONCEPTS

The formation of a partnership is similar to that of a sole proprietorship. The investments
of the partners are given proper accounting recognition by debiting the amount of
investment and crediting the partner s capital account.

The pro forma entry for the partner's contribution is as follows:

Assets xx
Partner, Capital xx

Assets refers to the contributions of the partners during partnership formation or any
additional investment made during the year.

Partner may contribute any of the following:

1. Cash
2. Property
3. Industry

The basic valuation guidelines that must be observed are as follows:

1. Cash is contributed. The value of the contribution is equal to the face value of
the cash. The value is easily determined by referring to the amount that appears
on the bills and coins.
The pro forma journal entry
Cash xx
Partner, Capital xx

2. Non-cash asset is contributed. The value of the contribution is equal to the

following:
a. The agreed amount in case there is a partner’s agreement.
b. The fair market value of property in the absence of a partner’s agreement. It
is emphasized that the agreement of the partners always prevails, provided
that the agreement is not contrary to laws, morals, good customs, public
order, or public policy.

The common non-cash assets contributed by the partners usually take the form of the
following:

a. Receivable contribution. In case accounts receivable with allowance for

doubtful accounts are contributed, both the gross amount and the allowance
will be recorded in the books of the partnership. On the contrary, specific
accounts receivable deemed worthless are not included.

In other words, when the collectability of the receivables contributed by a partner is

doubtful, the allowance must be maintained in the books of the partnership. The partner
will be credited by the net amount (i.e., receivable minus the allowance for doubtful
account).

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 The pro forma entry for the contribution is as follows:

Accounts receivable (gross amount) xx

Allowance for doubtful account xx
Partner, Capital xx

However, when the receivable is already deemed worthless, it will be removed and only
the net amount will be credited to the partner contributing the receivable.

The pro forma entry for the contribution, assuming all the allowances for doubtful
accounts have been removed, is as follows:

Accounts receivable (net amount) xx

Partner, Capital xx

b. Inventories contribution. Contribution in the form of inventories is recorded

based on the agreed amount, regardless of the cost of inventories.
However, at the end of the accounting period, proper adjustment must be
made on the inventory valuation based on the Philippine Financial Reporting
Standards (PFRS) requirements.

In other words, the amount to be credited to the investing partner is based on the agreed
amount of the inventory, regardless of whether the agreed amount is higher or lower
than the cost. Similarly, the fair market value of the inventory is disregarded in case there
is a
partners agreement.

The pro forma entry for the contribution is as follows:

Merchandise inventory xx
Partner, Capital xx

c. Property, plant, and, equipment contribution. In the event a partner

contributes a non-cash asset with accumulated depreciation, the asset must
be recorded in net amount in the books of the partnership.

In other words, the accumulated depreciation account is not carried to the books of the
partnership.

The pro forma entry for the contribution is as follows:

Property and equipment (net of depreciation) xx

Partner, Capital xx

d. Service or industry is contributed. When service or industry is contributed by

an industrial partner, no value is provided for the services since its value
cannot be quantified unless it is paid for. The contribution is recorded,
however, by means of a memorandum entry in the capital account of the
partner.

METHODS OF FORMING A PARTNERSHIP

The three ways of forming a partnership are as follows:

1. Two or more persons, not engaged in business, form a partnership tor the first
time.
2. An individual and a sole proprietor, or two or more sole proprietors form a
partnership.
3. A new partner is admitted in an existing partnership.

METHOD 1: TWO OR MORE PERSONS, NOT ENGAGED IN BUSINESS, FORM A

PARTNERSHIP FOR THE FIRST TIME

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A person not engaged in business does not maintain any books of accounts. Since it is
the first time for the individual partners to engage in a similar business, they have no
alternative but to use a set of books to record the day-to-day business activities under
this method of partnership formation. The books of accounts refer to the journal and
ledger.

Journal is the book of original entry while

Ledger is the book of final entry.

Illustration 2.1

On January 1, 2022, Jenny and Yvone, both not engaged in business, decided to form a
business partnership for the first time. Each partner contributed 300,000 cash.

Required: Prepare the entry recording the formation of the partnership.

Answer: The entry in the books of partnership on January 1, 2022 is as follows:

Cash 600,000
Jenny, Capital 300,000
Yvone, Capital 300,000

This opening entry is similar to the entry discussed in accounting for sole proprietorship.
However, there are already two or more owners in this case. As a reminder, journal
entries are recorded in a two-column general journal, unless the partnership adopts the
special journals.

Illustration 2.2

On July 1, 2022, Nicanor and Angel agreed to form a business partnership with the
following investments:

Nicanor Angel

Cash P 100,000 P 150,000

Accounts Receivable 90,000 120,000
Allowance for Doubtful Accounts 15,000 10,000
Merchandise Inventory 200,000 150,000

The Partners agree to the following conditions:

1. The specific accounts receivable of Nicanor amounting to P10,000 is not
included.
2. The allowance for doubtful accounts of Angel is increased to P17,000.
3. The merchandise inventory of Angel is valued at its net realizable value of
P190,000.
4. The fair market value of Nicanor’s inventory amounts to P158,000.

Required: Prepare the entry recording the formation of the partnership.

Answer: Before the contributions of the partners are recorded, they must be properly
adjusted to reflect the correct amount of investment.

The adjusted is computed as follows:

Angel
Capital Account before adjustment
(P150,000 + P120,000 – P10,000 + P150,000) P 375,000
Adjustment: Increase in allowance for doubtful accounts

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 (P17,000 – P15,000) (2,000)
Increase in Merchandise Inventory
(P190,000 – P150,000) 40,000
Adjusted Capital of Angel P 443,000

Nicanor
Capital Account before adjustment
(P100,000 + P90,000 – P15,000 + P200,000) P 410,000
Adjustment: Write-off of specific receivable (10,000)
Decrease in Merchandise Inventory
(P200,000 – P158,000) (42,000)
Adjusted Capital of Nicanor P 323,000

The entry in the books of Partnership on January 1, 2020 is as follows:

Cash 250,000
Accounts Receivable 200,000
Merchandise Inventory 348,000
Angel, Capital 443,000
Nicanor, Capital 323,000
Allowance for doubtful Accounts 32,000

In the absence of any agreement, the fair market value is used in valuing the
contributions of the partners.

Illustration 2.3

On April 1, 2022, Princess and Hyzel agreed to form a business partnership for the first
time with the following investments:

Princess
Cash P250,000
Accounts receivable 180,000
Allowance for doubtful accounts 10,000
Merchandise Inventory 160,000

Hyzel
Cash P200,000
Merchandise Inventory 200,000
Delivery Equipment 350,000
Accumulated Depreciation 75,000

The partners agreed to the following conditions:

1. The accounts receivable of Princess are recorded at their net realizable value of
P160,000.
2. The merchandise inventory of Princess is valued at P180,000.
3. The fair market value of delivery equipment amounts to P250,000.
4. The merchandise inventory of Hyzel is valued at its recoverable amount of
P190,000.

Required: Prepare the entry recording the formation of the partnership.

Answer: The contributions of partners are adjusted as follows:

Princess
Capital accounts before adjustment
(P250,000 + P180,000 – P10,000 + P160,000) P580,000
Adjustment: Increase in allowance for doubtful accounts
(P160,000 – P275,0000 (10,000)
Increase in Merchandise Inventory

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 (P180,000 – P160,000) (20,000)
Adjusted capital of Princess P590,000

Hyzel

Capital accounts before adjustment

(P200,000 + P200,000 + P350,000 – P75,000) P675,000
Adjustment: Reduction in value of delivery equipment
(P250,000 – P275,0000 (25,000)
Decrease in Merchandise Inventory
(P190,000 – P200,000) (10,000)
Adjusted capital of Hyzel P640,000

To record the formation of the partnership, the following entry is made:

Cash 450,000
Accounts receivable 160,000
Merchandise Inventory 370,000
Delivery Equipment 250,000
Princess, Capital 590,000
Hyzel, Capital 640,000

The merchandise inventory of Princess is recorded based on the agreement of the

partners. This is despite the cost of P160,000 which is lower than the fair market value or
net realizable value of P20,000.

However, the different accounting values will be valued in accordance with the PFRS
requirements by the end of the year. For example, the merchandise inventory account
will be valued at its cost or net realizable value, whichever is lower.

Furthermore, the accumulated depreciation account applicable to the delivery equipment

is not taken up in the books of the partnership. It has a different accounting treatment
from the allowance for doubtful accounts in recording the partnership formation.

Illustration 2.4

Izzy, Christlord, and Kale agreed to form a business partnership on May 1, 2022 with the
following investment:

Izzy Christlord
Cash P150,000 P200,000
Merchandise Inventory 100,000 120,000

Kale contributes his managerial skills by handling the day-to-day operation of the
partnership for 1/3 of the interest of the partnership.

Required: Prepare the entry recording the formation of the partnership.

Answer: To record the partnership formation, the following entry is made:

Cash 350,000
Merchandise Inventory 220,000
Izzy, Capital 250,000
Christlord, Capital 320,000

This journal entry does not reflect the investment of Kale in the form of services rendered
to the partnership. However, in Kale’s capital account, the following memorandum entry
is made:

Kale, Capital
Contributed managerial skill; handles the day-to-day operation

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 with one-third interest in the partnership.

A memorandum entry is usually reflected in the ledger of the partner. This type of entry is
not recorded in the journal since there are no accounts to be debited or credited, and
there are no available amounts to be recorded.

METHOD 2: An Individual and a Sole Proprietor, or Two or More Proprietors Form

a Partnership.

Relative to the recording process under this method, there are two alternatives of
partnership formation that can happen. These are as follows:

1. An individual without a business and an existing sole proprietor form a

partnership.
2. Two or more sole proprietors form a partnership.

Alternative 1: An Individual and an Existing Sole Proprietor Form a Partnership

An individual not engaged in any business and becomes a partner in a partnership does
not have any books of accounts. On the other hand, a sole proprietor who becomes a
partner maintains a complete set of books.

Therefore, there is a necessity for the partners agree on a provision in which books or
accounts will be used by the partnership.

The resulting agreement may follow the following scenario, as required by the National
Internal Revenue Code (as amended):

A new set of books will be used by the partnership.

The accounting procedures to perform in this case consists of the following steps:
 Adjust the books of the sole proprietorship based on the agreement of the
partners. Adjustment cost are directly charged to the capital account of the
owner.
 Close the books of the sole proprietorship.
 Record the investment of the partners in the new set of books.

Alternative 2: Two or More Sole Proprietors Form a Partnership

In this alternative, each proprietor has a complete set of books of accounts. The partners
must, therefore, agree on which books will be used by the partnership, whether they are
the existing ones or a new set of books.

Thus, the possible scenario follows:

A new set of books will be used by the partnership.

The accounting procedure to perform in this case is as follows:

 Adjust all the books of sole proprietorship based on agreement.
 Close all the books of sole proprietorships.
 Record the investments of the partners in a new set of books.

Illustration 3.1

On June 1, 2022, Justin and Gian agreed to form a partnership by pooling together their
available resources. Justin has been operating a sole proprietorship prior to the
partnership formation with the following account balances:

Cash P120,000
Accounts Receivable 150,000
Allowance for doubtful accounts (12,000)

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 Merchandise inventory 300,000
Equipment 180,000
Accumulated depreciation (40,000)
Accounts Payable 100,000

Gian made the following contribution after the records of Justin have been properly
adjusted:
Cash P200,000
Merchandise 400,000

The two agreed to adjust the books of Justin as follows:

1. The allowance for doubtful accounts is increased to P20,000
2. The value of merchandise inventory is understated by 715,000
3. The carrying amount of equipment amounts to 130,000.

Required: Prepare the entries necessary to record the formation of the partnership.

Answer: If a new set of books will be used by the partnership, the following procedural
steps should be performed in recording the formation of the partnership:

Step 1: Adjust the books of Justin as follows:

a. To adjust the allowance:

Justin, Capital 8,000

Allowance for doubtful accounts 8,000

b. To adjust the merchandise Inventory:

Merchandise Inventory 15,000

Justin, Capital 15,000

c. To adjust the equipment:

Justin, Capital 10,000

Accumulated depreciation 10,000

Step 2: Close the book of Justin after the accounts are properly adjusted as follows:

Justin, Capital 595,000

Allowance for doubtful accounts 20,000
Accumulated depreciation 50,000
Accounts Payable 100,000
Cash 120,000
Account receivable 150,000
Merchandise inventory 315,000
Equipment 180,000

In case this entry is properly posted, the records of Justin will be closed already.

Step 3: The last step is to record the formation of the partnership as follows:

Cash 320,000
Account receivable 150,000
Merchandise inventory 715,000
Equipment 130,000
Allowance for doubtful accounts 20,000
Accounts Payable 100,000
Justin, Capital 595,000
Gian, Capital 600,000

The equipment has been recorded at the net amount of the accumulated depreciation.

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Illustration 3.2

On March 1, 2022, Jocelyn, Josephine and Jennifer, all sole proprietor agreed to form
JJJ Partnership by pooling together their respective business resources as follows:

Jocelyn Josephine Jennifer

Cash P120,000 P150,000 130,000

Accounts receivable 90,000 100,000 120,000
Allowance for doubtful accounts (10,000) (8,000) (11,000)
Merchandise Inventory 250,000 280,000 230,000
Accounts Payable 80,000 90,000 70,000

The three agreed the following adjustments:

1. The accounts receivable was adjusted based on their net realizable values as
follows:
Jocelyn P75,000
Josephine 85,000
Jennifer 103,000

2. The merchandise is reduced by the following amounts:

Jocelyn P3,000
Josephine 2,000
Jennifer 3,000

Required: Record the formation of the partnership, and prepare a statement of financial
position.

Answer 1: If a new set of books will be used by the partnership, the following accounting
procedural steps should be followed:

Step 1: Adjust the books of the sole proprietorships as follows:

a. To adjust the books of Jocelyn:

Jocelyn, Capital 8,000

Allowance for doubtful accounts 5,000
Merchandise Inventory 3,000

b. To adjust the books of Josephine:

Josephine, Capital 9,000

Allowance for doubtful accounts 7,000
Merchandise Inventory 2,000

c. To adjust the books of Jennifer

Jennifer, Capital 9,000

Allowance for doubtful accounts 6,000
Merchandise Inventory 3,000

Step 2: Close the books of the sole proprietorships as follows:

a. To close the books of Jocelyn:

Jocelyn, Capital 362,000

Allowance for doubtful Accounts 15,000
Accounts Payable 80,000
Cash 120,000
Accounts Receivable 90,000

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 Merchandise Inventory 247,000

b. To close the books of Josephine:

Josephine, Capital 423,000
Allowance for doubtful Accounts 15,000
Accounts Payable 90,000
Cash 150,000
Accounts Receivable 100,000
Merchandise Inventory 278,000

c. To close the books of Jennifer:

Jennifer, Capital 390,000
Allowance for doubtful Accounts 17,000
Accounts Payable 70,000
Cash 130,000
Accounts Receivable 120,000
Merchandise Inventory 227,000

Step 3: Record the investments of the partners as follows:

Cash 400,000
Accounts receivable 310,000
Merchandise Inventory 752,000
Allowance for doubtful accounts 47,000
Accounts Payable 240,000
Jocelyn, Capital 362,000
Josephine, Capital 423,000
Jennifer, Capital 390,000

Answer 2: The statement of financial position of JJ Partnership after the formation

appears as follows:

JJJ Partnership
Statement of Financial Position
As of March 1, 2022

Assets Liabilities

Current Assets Current Liabilities

Cash P400,000 Accounts Payable P240,000
Accounts receivable P310,000 Total Current assets P240,000
Less: Allowance for
Doubtful accounts 47,000 263,000 Partner’s Capital
Merchandise Inventory 752,000
Jocelyn, Capital P362,000
Josephine, Capital 423,000
Jennifer, Capital 390,000 1,175,000
______ Total Liabilities
Total Assets P1,415,000 and Capital P1,415,000

Method 3: A New Partner is Accepted in an existing Partnership

When a new partner is accepted in an existing partnership, the old partnership is

immediately dissolved, and a new partnership is created.

The admission of a new partner implies that a new agreement is implicitly made among
the partners, thereby dissolving the old partnership and forming a new one.

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This type of partnership formation is further discussed in succeeding modules.

---------------------------------------------Nothing Follows--------------------------------------

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