Chapter # 11. Partnership Formation. Principles of Accounting B.Com Part I. Sameer Hussain

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1 Partnership Formation Principles of Accounting B.Com Part I

2 WHAT THE EXAMINER USUALLY ASK? General Journal entries. Initial Balance Sheet. Page 164

3 PARTNERSHIP FORMATION PARTNERSHIP Partnership is an association of two or more people (partners) formed for the purpose of carrying on a business. Partnerships are governed by Partnership Act Unlike an incorporated company, a partnership does not have a legal personality of its own and therefore partners are liable for the debts of firm. PARTNERSHIP DEED Partnership agreement in writing is called partnership deed. Partnership deed is a document which is signed by all the partners and which contains all the matters determining and governing the mutual rights, duties and liabilities of the partners in the conduct and management of the affairs of the partnership. It may also be referred to as articles of partnership containing the name, nature of business, capital, duration of the firm, etc. The partnership deed usually contains the following clauses. 1. Name and location of business. 2. The nature of the business. 3. The amount of capital to be contributed by each partner. 4. Provisions or reinvestment in business. 5. The duties, powers and obligations of all the partners. 6. Length or life of business. 7. The method of distribution of profit and sharing of the losses. 8. Method of admitting a new partner. 9. Procedure for withdrawal of a partner. 10. The method of valuation of goodwill on and or retirement or death of a partner. 11. Method of revaluation of assets or liabilities on admission, retirement or death of a partner. 12. Procedure to be followed for expulsion of a partner. 13. Arrangements to be followed in case a partner becomes insolvent. 14. Salary, if any, payable to the partners for managing the firm. 15. The method of preparing accounts and arrangement for audit. 16. Procedure for the dissolution of the firm and settlement of accounts. 17. Arbitration in case of disputes among partners. 18. Operation of bank account. Kinds of partners A person who provides his share in capital and also takes active part in Active Partner: the management. The development of business depends upon the active partners. Sleeping Partner: Silent Partner: Secret Partner: These partners only provide capital and also share the profit and loss of the business. A sleeping partner does not take part in the management of a firm. These are not known to public as a partner. A silent partner is known to the public as a partner. He does not participate in the affairs of the management. But be is liable to pay debts of the firm. He takes active part in the business but public does not know him as a partner of the firm. He is liable to pay all the debts of the firm. Page 165

4 Nominal Partner: Minor Partner: Senior Partner: Junior Partner: Limited Partner: Unlimited Partner: These partners do not share the profit and loss the firm. These do not participate in the management of a firm. A firm only uses the name and goods reputation of the partners. So these are called nominal partners. A minor may become partner with the consent all the partners. A minor is only admitted in the profits of the business only. He has no liability of loss. A person who is playing important role in the management according to his ability, experience and capital, is called senior partner. A person who has small investment in the firm and has a limited experience of business is called junior partner. A partner whose loss responsibility is restricted to his share only is called limited partner. He cannot take post in the management of a firm. When the liability of the partner is unlimited he is called unlimited partner. The debts of firm can be paid even by the personal property of the partner. Advantages of partnership The formation of partnership is very easy. Simply an agreement among Easy Formation: the partners in oral or written words can bring a partnership into existence. It includes very less legal formalities and expenses. Large Resources: Diverse Skills and Expertise: Flexibility of Operations: Sharing of Risk: Benefits of Unlimited Liability: A partnership is in a position to accumulate large resources as more than one contributes capital. The added financial strength of the partners can be utilized to increase the scale of operation of the business. New partners can be admitted to meet the additional requirement of fund. Partnership provides a scope for association of persons with diverse skills and expertise. Partners having expertise and skills in different functional areas of business can manage the business efficiently. Like that of sole proprietorship the partnership can bring changes in its operation easily and quickly looking at the changing circumstances. Such changes cannot be implemented in a company with ease because of the restrictions imposed. The losses of the firm and other associated risk in business are shared by the partners. Hence, the share of risk of each partner is less in comparison to sole proprietorship. Since the liability of the partners is unlimited it acts as great check against speculative activities and partners shall not be careless in managing the business. Further, the firm enjoys good credit standing and easily obtains loans because the creditors can realize their loan amount from the private property of the partners. Page 166

5 Close Supervision: Reduced Management Cost: Secrecy: Partners take active part in the management of the business. The close supervision of partners eliminates wastage and leads to greater efficiency. Since different functional areas are managed by the partners themselves, the huge managerial expenses can be saved to a great extent. There is no statutory obligation on the part of partnership to publish the accounts of the firm. Hence, the business secrecy can be maintained to a certain extent. Disadvantages of partnership There is a limit to the maximum number of partners in a partnership Therefore; the capital that can be raised from the partners is limited. Limited Capital: Large-scale business requires huge capital and partnership is not the proper form to meet the requirement. Unlimited Liability: Instability: Lack of Harmony: Non Transferability of Interest: Like that of the sole proprietorship, unlimited liability is an important drawback of partnership. The risk of loss of private property of the partnership influences the partners to avoid further risk and play safe. There is instability in existence because a successful firm can be dissolve on the death, insolvency or lunacy of a partner. The difference of opinion may also bring about closure of the business. The sudden closure of a successful business is a great social loss. Difference of opinion is the natural consequence in partnership. The conflicts and lack of harmony among the partners may not be beneficial for the business and sometimes even that lead to dissolution of the firm. No partner can transfer his interest in a firm to third party without the consent of the other partners. Thus, a partner does not enjoy the freedom of converting his interest in the firm into cash. Difference between sole proprietorship & PARTNERSHIP BASIS OF DIFFERENCE PARTNERSHIP SOLE PROPRIETORSHIP 1. Membership Partnership is owned by two or more persons subject to the limit ten in banking business and twenty in case of other business. Sole proprietorship is owned by one and only one person. 2. Formation 3. Regulating Law It is formed through an agreement which may be oral or in writing. It is governed by the rules contained under the Pakistan Partnership Act, It is formed quite easily as it is the outcome of a single person's decision without any legal administrative approval. There is no specific statutory law to govern the functioning of sole proprietors business. Page 167

6 BASIS OF DIFFERENCE PARTNERSHIP SOLE PROPRIETORSHIP There is more scope for It has a limited financial capability. 4. Capital: raising a larger amount of Hence, the scope for rising capital is capital as there is more naturally least. than one person. 5. Management 6. Risk 7. Quickness in Decision Making 8. Maintenance of Secrecy Every partner has the right to take active part in the management the affairs of the business. Each partner also enjoys the authority to bind the firm and other partners for his acts in the ordinary course of business. The risk connected with the business is comparatively less as it is shared all the partners. Decision-making in partnership is corporately delayed as the partners arrive at decision after the consultation with one another. Maintenance of absolute secrecy is not possible in of partnership as business secrets are accessible to more than one partner. The sole proprietorship is selfmanaged one and few employees may support him. However, the decision of the proprietor is final and binding. The risk of the sole proprietor is greater than that of partnership form business. The decision of the sole proprietor is prompt as he need not consult anyone. The sole proprietor need not share his business secrets with anybody. Difference between Company & PARTNERSHIP BASIS OF DIFFERENCE COMPANY PARTNERSHIP A company comes into In case of partnership, the 1. Registration existence only after its registration is not compulsory. registration under the Companies Act, Legal Status 3. Minimum Number of Persons 4. Maximum Number of Persons A company is a legal person and regarded by law as a single person. The minimum number of persons required to form a company is two in case of private companies and seven in the case of public companies. A public company may have any number of members. In case of a private company the maximum number cannot be more than fifty. A partnership is a collection of individual. The minimum number of persons required to form a partnership is two. In trading partnership the maximum number of partners is twenty, in a banking business, the maximum number is ten. Page 168

7 BASIS OF DIFFERENCE COMPANY PARTNERSHIP 5. Transferability A shareholder can transfer his share without the consent of other shareholders. 6. Liability of Members 7. Length of Existence 8. Statutory Obligations 9. Authority of Members 10. Distribution of Profits 11. Audit The liability of the members of a company is limited. Company having legal existence can continue inspite of death and insolvency of the members. A company is required to comply with various statutory obligations regarding management e.g.; filing balance sheet, maintaining prescribed registers. Management of a company vests in the hands of a few directors elected from amongst and by the shareholders. A shareholder has no say in the management. Profits in case of a company can be distributed according to the provision of the articles by the directors. Audit in case of company is compulsory. In case of partnership, a partner cannot transfer his share without the consent of other partners. The liability of partners for debts of a firm is unlimited. The death or retirement of a partner dissolves the partnership. In case of partnership, there are no statutory obligations. In the case of partnership all partners are entitled to share in the management of a firm. A partner is an agent of the firm and can bind it by his acts. Profits of a firm are distributed in agreed proportion or equally in absence of agreement among the partners In case of partnership firm it is not compulsory. FORMATION OF PARTNERSHIP Formation means the establishment of partnership. Two or more than two partners can form a partnership. Basically there are two situation of formation of partnership. One is that the partners are not doing their separate business and decided to form a partnership. It means that they do not have any separate business before the formation of partnership. Other situation is that the partners are sole traders and were doing their separate business and decided to form a partnership by merging their businesses. They merge their assets and liabilities at an agreed value. Page 169

8 ENTRIES TO RECORD FORMATION OF PARTNERSHIP If the partners are not doing their separate business: Cash/Other assets DR. (with investment amount) A s capital CR. (with investment amount) (To record the investment of A) Cash/Other assets DR. (with investment amount) B s capital CR. (with investment amount) (To record the investment of B) If the partners are sole traders: Cash/Other assets DR. (with investment amount) Accounts payable/other liabilities CR. (with liability amount) A s capital CR. (with net asset amount) (To record the investment of A) Cash/Other assets DR. (with investment amount) Accounts payable/other liabilities CR. (with liability amount) B s capital CR. (with net asset amount) (To record the investment of B) ILLUSTRATION # 1: (Formation by Investment of Partners) 2007 Private UOK Alia, Shahla and Huma formed a partnership on December 1, They contributed as under: Alia contributed Rs.200,000, Rs.80,000 in the shape on equipment, Rs.100,000 for machinery and Rs.20,000 for furniture. Shahla contributed Rs.180,000, Rs.80,000 in the shape of merchandise, Rs.60,000 for supplies and Rs.40,000 for furniture. Huma invested cash of Rs.220,000. It was further decided that all partners should contribute equally, being equal partners. Alia and Shahla invested further sufficient cash to give them interest equal to that of Huma. (1) Give necessary entries in General Journal of the firm to record the formation of partnership. (2) Prepare balance sheet of the firm immediately after the formation. SOLUTION # 1: PARTNERSHIP GENERAL JOURNAL FOR THE MONTH DECEMBER 2006 Date Particulars P/R Debit Credit 1 Cash 20,000 Equipment 80,000 Machinery 100,000 Furniture 20,000 Alia Capital 220,000 (To record the investment of Alia) Page 170

9 Date Particulars P/R Debit Credit 2 Cash 40,000 Merchandise 80,000 Supplies 60,000 Furniture 40,000 Shahla Capital 220,000 (To record the investment of Shahla) 3 Cash 220,000 Huma Capital 220,000 (To record the investment of Huma) PARTNERSHIP BALANCE SHEET AS ON 1 DECEMBER 2006 ASSETS EQUITIES Current Assets: Owner s Equity: Cash 280,000 Alia Capital 220,000 Merchandise 80,000 Shahla Capital 220,000 inventory Supplies 60,000 Huma Capital 220,000 Total current assets 420,000 Total owner s equity 660,000 Fixed Assets: Equipment 80,000 Furniture 60,000 Machinery 100,000 Total fixed assets 240,000 Total assets 660,000 Total equities 660,000 ILLUSTRATION # 2: (Formation by Merging of Business) 2001 Regular & Private BIEK On March 31, 2001 Naseem and Rasheed decided to form a partnership under the name of Mehran Traders by merging their individual businesses. On that date the agreed valued of each item of balance sheet were as under:- Item Naseem Rasheed Cash 20,000 50,000 Accounts receivable 40,000 25,000 Merchandise 35,000 60,000 Building 85,000 - Office equipment - 30,000 Allowance for bad debts 15,000 12,000 Accounts payable 45,000 33,000 Capital 120, ,000 (i) Prepare entries in General Journal of the firm to record the formation of partnership. (ii) Prepare initial balance sheet of the firm as on March 31, Page 171

10 SOLUTION # 2: MEHRAN TRADERS GENERAL JOURNAL FOR THE MONTH OF MARCH 2001 Date Particulars P/R Debit Credit 1 Cash 20,000 Accounts receivable 40,000 Merchandise inventory 35,000 Building 85,000 Allowance for bad debts 15,000 Accounts payable 45,000 Naseem Capital 120,000 (To record the investment by Naseem) 2 Cash 50,000 Accounts receivable 25,000 Merchandise inventory 60,000 Office equipment 30,000 Allowance for bad debts 12,000 Accounts payable 33,000 Rasheed Capital 120,000 (To record the investment by Rasheed) MEHRAN TRADERS BALANCE SHEET AS ON 31 MARCH 2001 ASSETS EQUITIES Current Assets: Liabilities: Cash 70,000 Accounts payable 78,000 Accounts receivable 65,000 Total liabilities 78,000 Less: All for bad debts (27,000) 38,000 Merchandise inventory 95,000 Owner s Equity: Total current assets 203,000 Naseem Capital 120,000 Rasheed Capital 120,000 Fixed Assets: Total owner s equity 240,000 Building 85,000 Office equipment 30,000 Total fixed assets 115,000 Total assets 318,000 Total equities 318,000 Page 172

11 Practice questions Question # 1: 2010 Regular & Private BIEK On February 2, 2010 Rafiq, Rahim and Rashid formed a partnership under the name of WWPF Brothers and agreed to share profit and loss in the ratio of 1:2:3 respectively. This ratio is determined on the basis of capital contributed by each partner. As per agreement the total capital of the firm shall be Rs.1,080,000. Rafiq: Contributed cash Rs.60,000 & Machinery Rs.120,000. Rahim: Contributed furniture worth Rs.200,000 and sufficient cash for the balance. Rashid: Contributed sufficient cash. Journal entries in the books of WWPF Brothers. Question # 2: 2009 Regular & Private BIEK Mumtaz, Ishaq and Khurshid agreed to form a partnership business with capital contribution in the form of cash and in the ratio of 3:2:1 respectively. Ishaq invests Rs.75,000 as his share of capital contribution. Find the investment of each partner and record in General Journal. Question # 3: 2003 Regular & Private UOK On March 21, 2003, Mobeen & Zulfi agreed to form a partnership. Mobeen invested equipment at agreed value of Rs.80,000 the original cost of which was Rs.100,000 and accumulated depreciation was Rs.20,000. Zulfi invested merchandise costing Rs.40,000 at an agreed value of Rs.50,000 along with his supplier, credit value of Rs.10,000 and sufficient cash to make his capital equal to Mobeen. (i) Prepare journal entries to record the partner s investment. (ii) Prepare initial balance sheet of the partnership firm. Question # 4: 2002 Private BIEK Mr. Wall Mart and Mr. Marshall were carrying on their independent businesses. The financial position on January 1, 2001 was as under: Wall Mart Marshall Cash Rs.1,500,000 Rs.1,600,000 Accounts receivable Rs.100,000 Rs.150,000 Merchandise inventory Rs.1,000,000 Rs.1,500,000 Land & building Rs.1,000,000 Rs.2,000,000 Office equipment Rs.200,000 Rs.250,000 Accumulated depreciation (on office equipment) Rs.25,000 Rs.94,000 Allowance for bad debts Rs.5,000 Rs.6,000 Accounts payable Rs.170,000 Rs.400,000 Capital, Wall Mart? Capital, Marshall? On Jan. 1, 2001, both of them decided to amalgamate their businesses and form a partnership, titled Marshall Wall Mart. They agreed to take their assets and liabilities at their book values in the new partnership firm. They further agreed to make their capitals at par with each other i.e. Rs.4,000,000/- each. Shortage to agreed capital, if any, is to be made up by the partner by investing an additional amount in cash from his personal resources and excess, if any, is to be withdrawn in cash from the business of newly formed firm. (i) Pass general journal entries in the books of new partnership firm Marshall Wall Mart, on Jan. 1, (ii) Prepare an initial balance sheet of new partnership firm on Jan, 1, Page 173

12 Question # 5: 1991 Regular & Private BIEK Rahim and Saleem were doing separate business. On January 1, 1990 they decided to form a partnership by merging their business. On this date their balance sheet items were as under:- Rahim Saleem Cash 13,000 8,000 Accounts receivable 20,000 15,000 Merchandise inventory 21,000 26,000 Furniture Cost 20,000 10,000 Allowance for depreciation-furniture 5,000 1,000 Allowance for bad debts 1, Accounts payable 8,000 20,000 The partners agreed to the following values:- Mr. Rahim Accounts receivable be estimated to realize Rs.18,000, Merchandise inventory be valued at Rs.22,000. Furniture be valued at Rs.12,000. One half of the accounts payable be accepted. Mr. Saleem Accounts receivable be valued at Rs.14,000. Merchandise inventory be valued at Rs.20,000. Furniture be valued at Rs.5,000. Three-fourth of the amounts of accounts payable be accepted. It was also decided that Saleem will invest sufficient cash to give him equal interest with Rahim. (a) Give entries in General Journal of the new firm to record the investment of Rahim and Saleem. (b) Prepare initial Balance Sheet of the firm. Question # 6: 1997 Regular & Private BIEK Jawaid and Junaid are sole traders, were carrying on competing business. On March 1, 1997, they decided to form a partnership under the name of JJ Corporation by merging their business. On that date their balance sheet items were as follows:- Jawaid Junaid Cash 7,000 10,500 Accounts receivable 35,000 42,000 Merchandise inventory 28,000 17,500 Office furniture 52,500 42,000 Allowance for depreciation Office furniture 28,000 14,000 Allowance for bad debts 4,000 5,000 Accounts payable 24,000 27,000 The following valuations were agreed upon:- (i) Jawaid s accounts receivable were estimated to realize Rs.30,000 and his office furniture was valued at Rs.40,000. (ii) Junaid s accounts receivable were estimated to realize Rs.38,000 and his office furniture was valued at Rs.9,000. (a) Give entries in the General Journal of the firm to record the investment by Jawaid and Junaid. (b) Prepare initial balance sheet of the firm. Page 174

SUBJECT: COMMERCE Class: 11 (ISC) Chapter 6: Partnership Date: 30 th July, 2018

SUBJECT: COMMERCE Class: 11 (ISC) Chapter 6: Date: 30 th July, 2018 A partnership is a voluntary association of two or more persons who agree to carry on some business jointly and share profits and losses.