CHAPTER 3
Partnership Dissolution
Dissolution
● Is the change in the relation of the partners caused by
any partner being disassociated from the business.
● Is the change in relation of the partners caused by
any partner ceasing to be associated in the carrying
on as distinguished from the winding up of the
business of the partnership (CCOP, Article 1828).
Dissolution
● Does not necessarily terminate the business. The
business continues until the remaining partners
decide to liquidate the business.
● A process of closing down a company.
Liquidation
● Is the termination of business operations or the
winding up of affairs.
● Refers to the process of selling all of a company’s
assets to generate cash to pay off creditors, or
anyone the company owes money to.
Causes of Dissolution
● Admission of partner
● Withdrawal, retirement or death of a partner
● Incorporation of a partnership
Admission of a Partners
The admission of a new partner may be effected
either through:
a. Purchase of interest in the partnership
b. Investment in the Partnership.
●
A new partner can only be admitted into a partnership
with the consent of all the continuing partners.
Delectus Personae: No one becomes a member of the
partnership without the consent of all members.
Liability of Incoming Partner for Existing Obligations
A person admitted as a partner into an existing partnership is liable
for all the obligations of the partnership incurred before his admission
as though he had been a partner when such obligations were
incurred. Such liability is limited to his capital contribution, unless
otherwise agreed.
Illustration:
Milavel Nazario, Martin Penaco and Ricardo Pangan
formed NPP, a general professional partnership, with a
capital of P 50,000 each on Feb. 14, 2016. On Apr. 8, the
partnership incurred an obligation of P 200,000 to Teresita
Buenaflor which will be payable on Dec. 16. On June 13,
Bienvenida Alvaro was admitted into the partnership; she
contributed P 20,000.
(a) Purchase of an Interest from Existing Partners
With the consent of all continuing partners, a person may be
admitted into an existing partnership by purchasing an interest
directly from one or more of the existing partners.
As such, any consideration paid or received by a
partner is not recorded in the partnership’s books. The
only entry to be made in the partnership’s book is a transfer
within equity.
Illustration:
PURCHASE OF INTEREST
The capital balances and profit and loss ratios of the
partners in ABC Co. are as follows:
Capital
40,000
60,000
80,000
180,000
A
B
C
Total
P/L
40%
30%
30%
CASE 1: PURCHASE OF INTEREST FROM ONE
PARTNER
D purchases one-half of C’s capital interest for P 48,000.
Requirement: Provide the journal entry to record the
transaction.
Solution:
C, Capital (80,000 x ½)
40,000
D, Capital
40,000
To record the admission of D to the
partnership
The P48,000 payment of D to C is not recorded in the
partnership’s books.
CASE 2: PURCHASE OF INTEREST FROM MORE THAN
ONE PARTNER
D purchases 25% of A’s, B’s and C’s capital interests for
P60,000.
Requirements:
a. Provide the journal entry to record the transaction.
b. How much are the capital balances of the partners
after the admission of D?
c. How much is the gain or loss to be recognized in the
partnership’s books?
d. How is the payment of D divided between the old
partners and how much are the old partner’s
respective personal gains?
Requirement (a):
A, Capital (40,000 x 25%)
10,000
B, Capital (60,000 x 25%)
15,000
C, Capital (80,000 x 25%)
20,000
D, Capital
45,000
To record the admission of D to the partnership
Requirement (b):
A
B
C
D
Totals
Capital, beg.
40,000 60,000 80,000 - 180,000
Sale of Interest to D (10,000) (15,000) (20,000) 45,000 Capital, end.
30,000 45,000 60,000 45,000 180,000
Notice that when a new partner is admitted through “purchase of
interest,” the total capital of the partnership does not change (the total capital
before and after the admission of D remains at P 180,000).
Requirement (c):
Zero. No gain or loss is recognized in the partnership’s
books when a new partner is admitted.
Requirement (d):
The old partners divide the payment of D based on whatever
they have agreed upon or as follows:
A
B
C
TOTAL
Debit to capital
Account
10,000 15,000 20,000
45,000
Excess allocated
based on P/L
ratio (60k payment
of D - 45k credit to D)
x 40%; 30%; & 30%
6,000
4,500
4,500
15,000
Share in the
Payment of D
16,000 19,500
24,500
60,000
Debit to capital
account
10,000 15,000
20,000
45,000
Personal gain (loss) 6,000
4,500
4,500
15,000
The personal gains of the selling partners are not recorded in
the partnership’s books.
CASE 3: PURCHASE OF INTEREST - BOOK VALUE
METHOD
D purchases 20% interest from A and B for P 50,000.
The partners agreed to account for the sale at the ‘book
values’ of A’s and B’s capital accounts (rather than the total
partnership capital).
Requirement: Provide the journal entry to record the
transaction.
A, Capital (40,000 x 20%)
B, Capital (60,000 x 20%)
D, Capital
8,000
12,000
20,000
CASE 4: PURCHASE OF INTEREST - PROPORTIONATE
SHARE
D purchases 20% interest in the net assets and
profits of the partnership from A and B for P 50,000. A and
B agreed to share proportionately on the 20% interest
sold to D. The partnership’s net assets are fairly valued on
D’s admission date.
Requirement: How much is the combined gain of A and B
from the sale?
Payment of D
Capital credit given to D
(180k total net assets x 20%)
Combined personal gain of A and B
50,000
36,000
14,000
A, Capital (36,000 x 40%/70%) a
20,571
B, Capital (36,000 x 20%) x 30%/70%) a 15,429
D, Capital (180k net assets x 20% interest) 36,000
(a) Fractions derived from A’s and B’s P/L ratios of
40% and 30%, respectively.
The new P/L ratios after D’s admission are as follows:
A [40% - (20% x 4/7)]
B [30% - (20% x 3/7)]
C
D
28.57%
21.43%
30.00%
20.00%
100.00%
INVESTMENT OF ASSETS IN A PARTNERSHIP
A person may be admitted into a partnership by
investing cash or other assets in the business. The assets are
invested into the partnership and not given to the individual
partners. The investment will increase the total assets and the
total partners’ equity.
Total Contributed Capital. It is the sum of the capital
balances of the old partners and the actual investment of the
new partner.
Total Agreed Capital. It is the total capital of the partnership
after considering the capital credits given to each of the
partners. Under the bonus method, total agreed capital is
equal to the total contributed capital though the capital credits
to each partner may be equal to, greater than or less than his
capital contribution.
Bonus. It is the amount of capital or equity transferred by one
partner to another partner.
Capital Credit. It is the equity of a partner in the new
partnership and is obtained by multiplying the total agreed
capital by the applicable percentage interest of the partner.
(b) Investment in the Partnership
Instead of purchasing interest from the existing
partners, a new partner may be admitted by investing directly
into the business. This transaction is a transaction between
the new partner and the partnership. As such, the
consideration paid by the incoming partner is recorded in the
partnership’s books. Because this is an equity transaction with
an owner, no gain or loss is recognized.
The following scenarios may occur when a new
partner invests in a partnership:
1. The incoming partner’s investment is equal to his/her
capital credit which may be determined by multiplying
the incoming partner’s interest with the partnership’s
net assets after the admission. The entry is simply a
debit to the invested asset and credit to the incoming
partner’s capital.
2. The incoming partner’s investment is greater than
his/her capital credit. The excess contribution is
treated as a bonus to the old partners to
compensate for their part efforts in establishing the
business. The bonus is accounted for as an increase
in the old partners’ capital and a decrease in the new
partner’s capital.
3. The incoming partner’s investment is less than
his/her capital credit. The deficiency is treated as a
bonus to the new partner (possibly because he/she
is bringing expertise or special skill into the business).
The bonus is accounted for as an increase in the new
partner’s capital and a decrease in the old partners’
capital.
Illustration: INVESTMENT IN THE PARTNERSHIP
The capital balances of the partners in ABC Co. are as
follows:
Capital
P/L ratio
A
40,000
40%
B
60,000
30%
C
80,000
30%
Total
180,000
The carrying amount of the net assets approximates fair
value.
Case 1: Investment equal to Capital Credit
D invests P 60,000 cash for a 25% interest in the
partnership’s net assets and profits.
Requirement: Provide the journal entry to record the
transaction.
Solution:
Net assets before admission
Investment of D
Net assets after admission
D’s interest in net assets
25%
D’s capital credit
Investment of D
Bonus
P 180,000
60,000
240,000
60,000
60,000
-
Cash
Note:
●
●
60,000
D, Capital (180k + 60k) x 25%
60,000
to record the admission of D to the partnership
Under
investment in the partnership, the
consideration paid by the new partner is recorded in
the partnership’s books. This results in an increase in
the partnership capital.
After the admission of D, the total capital of the
partnership is increased to P240,000 (180k before D’s
admission + 60k D’s investment).
A comparison between purchase of interest and investment in
the partnership is provided below:
Purchase of Interest
Investment in the
partnership
The
incoming partner’s
contribution is not recorded
in the partnership’s books.
The
incoming partner’s
contribution is recorded in
the partnership’s books.
Partnership capital remains
the same before and after
the
admission of the
incoming partner.
Partnership
capital
is
increase by the incoming
partner’s contribution.
No
gain
or loss is
recognized
in
the
partnership’s books.
No
gain
or loss is
recognized
in
the
partnership’s books.
Case 2: Bonus to old Partners
D invests P 80,000 cash for a 25% interest in the
partnership’s net assets and profits.
Requirement: Provide the journal entry to record the
transaction and determine the capital balances and profit
and loss sharing ratio of the partners after the admission of
D.
Solution:
Net assets before admission
Investment of D
Net assets after admission
D’s interest in net assets
25%
D’s capital credit
Investment of D
Bonus
P 180,000
80,000
260,000
65,000
80,000
(15,000)
Cash
80,000
D, Capital (180k + 80k) x 25%
65,000
A, Capital (15k x 40%)
6,000
B, Capital (15k x 30%)
4,500
C, Capital (15k x 30%)
4,500
to record the admission of D to the partnership
The bonus is allocated to the old partners based on their old
P/L ratio.
The capital balances of the partners after the admission of D
are determined as follows:
A
B
C
D
Total
Capital, before
admission
40,000 60,000 80,000
180,000
Investment of D
80,000 80,000
Bonus to old
partners
6,000 4,500 4,500 (15,000)
Capital, after
admission
46,000 64,500 84,500 65,000 260k
A (100% - 25%) x 40%
B (100% - 25%) x 30%
C (100% - 25%) x 30%
D
New P/L ratio
30.00%
22.50%
22.50%
25.00%
100.00%
Case 4.1: Amount of Investment
D wants to join the partnership through direct investment. D
asks the existing partners how much should he invest for a
20% interest in the partnership’s net assets and profits. The
partnership’s books include a receivable from A of P8,000
and a loan payable to B of P10,000.
Requirement: If no bonus is allowed, how much should D
invest?
Solution:
Net assets before admission
P 180,000
Divide by: (100% - 20% interest of D
80%
Net assets after admission
225,000
Multiply by: D’s interest in net assets
20%
D’s investment
45,000
● Checking: (180k + 45k) x 20% = 45k D’s capital
credit equal to his investment.
The partners’ receivable and payable accounts do not
affect the computations above because the business is
continued after the partnership dissolution. These accounts
are carried over to the books of the new partnership.
Case 4.2: Adjustment to Capital and Cash Settlement
After D’s admission in Case 4.1’, the partners agreed to
adjust their capital balances to reflect their proportionate
shares in the partnership’s net assets based on their new
profit and loss ratio. Cash settlement will be made among
the partners.
A (100% - 20%) x 40%
B (100% - 20%) x 30%
C (100% - 20%) x 30%
D
A
B
Capital, before
admission
40,000 60,000
Investment of D
Total
40,000 60,000
Adjusted
capital
72,000 54,000
(payment)/
receipt
(32,000) 6,000
New P/L ratio
32%
24%
24%
20%
100.00%
C
D
Total
80,000
180,000
45,000 45,000
80,000 45,000 45,000
54,000 45,000 225,000
26,000
-
-
[Adjusted Capital Formula: 225k x 32%; 24%; & 20%)
● In the cash settlement, A pays B P6,000 and C
P26,000.
B, Capital
6,000
C, Capital
26,000
A, Capital
32,000
to record the partners’ a agreed capital adjustment
Case 4.3: Correction of Errors
In Year 3, two years after D’s admission in ‘Case 4.1’, the
partnership earned a profit of P1,000,000. However, it was
discovered that the following items were omitted in the
partnership’s books:
Year 2
Year 3
Prepaid Asset
35,000
50,000
Accrued Expense
40,000
60,000
Requirement: How much is the share of A in the Year 3
profit?
Solution: recall the following concepts on correction of prior
period errors:
● If an asset-related account is understated, profit
is also understated (Direct relationship). The
opposite applies to a liability-related account.
● Counterbalancing errors automatically reverse in
the immediately following period if not corrected.
Year 2
Year 3
Unadjusted Profit
1,000,000
Understatement of
prepaid asset in Year 2
35,000
(35,000)
Understatement of
prepaid asset in Year 3
50,000
Understatement of
accrued expense in Year 2
(40,000)
40,000
Understatement of
accrued expense in Year 3
(60,000)
Adjusted Profit
995,000
Multiply by: A’s P/L ratio (see solution in 4.2)
32%
Share of A in Year 3 profit
318,400
Goodwill Method
In traditional accounting (i.e., based on US GAAP), an
additional method called “goodwill method” is used to
recognize an implied value from a partner’s contribution
during admission (and payment to a partner during the
withdrawal). This method, however, has been outlawed by
PFRS 3 Business Combinations.
Illustration: Goodwill Method
Capital Accounts
A, Capital
150,000
B, Capital
250,000
400,000
P/L ratios
40%
60%
Case 1: Purchase of Interest - Goodwill to old Partners
C purchases 20% from A and B for P100,000. The partners
agreed to recognize an implied goodwill from C’s payment.
Cs payment
Divide by: C’s interest
Grossed-up value of partnership’s net assets
Actual contributed capital
Goodwill
Goodwill
A, Capital (100k x 40%)
B, Capital (100k x 60%)
A, Capital (150k + 40k) x 20%
B, Capital (250k + 60k) x 20%
C, Capital
100,000
20%
500,000
400,000
100,000
100,000
40,000
60,000
38,000
62,000
100,000
Case 2: Investment - Goodwill to old Partners
C invests P120,000 to the partnership for a 20% interest.
The partners agreed to recognize an implied goodwill from
C’s investment.
Cs investment
Divide by: C’s interest
Grossed-up value of partnership’s net assets
Actual contributed capital
Goodwill
Actual Contributed capital formula:
commission + 120k C’s investment)
Goodwill
A, Capital (80k x 40%)
B, Capital (80k x 60%)
Cash
C, Capital
120,000
20%
600,000
520,000
80,000
(400k
80,000
32,000
48,000
120,000
120,000
before
Case 3: Investment - Goodwill to new Partner
C invests P90,000 to the partnership for a 20% interest.
The partners agreed to have a total capital of P500,000.
Cash
90,000
Goodwill (squeezed)
10,000
C, Capital (500k ‘agreed capital’ x 20%)
100,000
The equity structure of the new partnership after the
admission of C is analyzed as follows:
Case 1
Case 2
Case 3
A, Capital
152,000
182,000
150,000
B, Capital
248,000
298,000
250,000
C, Capital
100,000
120,000
100,000
Total Capital
500,000
600,000
500,000
Actual Contributed
capital
400,000
520,000
490,000
Overstatement
(equal to GW) 100,000
80,000
10,000
“Goodwill,” by its inherent nature, is difficult to
measure with sufficient reliability, and it has the tendency to
be measured arbitrarily. PFRS 3 prohibits the recognition of
goodwill from transactions that are not business
combinations. The illustrations above are provided solely for
illustration purposes.
Withdrawal, retirement or death of a partner
When a partner withdraws, retires or dies, his interest may be
(a) purchased by one or all of the remaining partners or (b)
settled by the partnership. In case of death, the deceased
partner’s estate is entitled to the value of the partner’s interest
at the date of his death.
The interest of the withdrawing, retiring, or deceased
partner is adjusted for the following:
a. His share of any profit or loss during the period up
to the date of his withdrawal, retirement or death; and
b. His share of any revaluation gains or losses as at
the date of his withdrawal, retirement, or death.
Purchase by one or all of the remaining partners. One or all of
the remaining partners may purchase the interest of the
retiring, withdrawing, or deceased partner. This is a
transaction between and among the partners (or deceased
partner’s estate). As such, the settlement amount is not
recorded in the partnership’s books. The only entry to be
made is a transfer within equity. However, the above
mentioned adjustments (i.e., share in profits or losses and
revaluation gains or losses) are recorded first before the
settlement.
Settlement by the Partnership. The partnership may settle the
interest of the retiring, withdrawing, or deceased partner. This
is a transaction between the retiring or withdrawing partner (or
deceased partner’s estate) and the partnership. As such, the
settlement amount is recorded in the partnership’s books,
alongside any other necessary adjustments.
Bonus method. When the outgoing partner’s interest is settled
at an amount greater than or less than the value of his
interest, the bonus method is used. Under the bonus
method, any excess (or deficiency) in the payment is
accounted for as deduction from (or addition to) the remaining
partner’s capital accounts.
Deferred Settlement. Pending settlement, the outgoing
partner’s interest is transferred to a liability account, which is
considered an ordinary claim, to subordinate to the claims of
other outside creditors (Art. 1841).
It may also be agreed that interest shall accrue on the
outgoing partner’s unpaid balance from the date of his
disassociation up to the date of settlement. In lieu of interest,
the partner may be entitled to profits attributable to the use of
his right in the property of the dissolved partnership (Art.
1841).
Solution: the partners’ capital accounts are adjusted for the
P900,000 profit. After the adjustment, the balance of C’s
capital account is P550,000. (See computation in Case 1
above).
Illustration 1: Withdrawal, retirement or death of a
partner
Fact Pattern:
The capital account balances of the partners in ABC
Partnership on July 1, 20x1 before any necessary
adjustments are as follows:
A, Capital (20%)
B, Capital (30%)
C, Capital (50%)
Total
150,000
250,000
100,000
500,000
The partnership reported profit of P900,000 for the six
months ended June 30, 20x1.
Case 1: Withdrawal - Purchase of interest by remaining
partners
On July 1, 20x1, C withdraws from the partnership when he
was bought-out by his co-partners for P620,000 cash.
The net assets of the firm as of this date approximate their
fair values.
Requirement: Provide the journal entries.
Solution: The capital balances of all of the partners are
adjusted for their respective shares in the profit accruing as
of the date of C’s withdrawal.
A(20%)
B(30%) C(50%) Total
Unadjusted Balance 150,000 250,000 100,000 500k
Share in Profit [900k x
(20%;30% & 50%)] 180,000 270,000 450,000 900k
Adjusted balance 330,000 520,000 550,000 1,400k
● The adjusting entry is as follows:
July 1 Income Summary
900,000
A, Capital
180,000
B, Capital
270,000
C, Capital
450,000
●
The entry to record the withdrawal of C is as
follows:
July 1 C, Capital
550,000
A, Capital (550k x 20%/50%)
220,000
B, Capital (550k x 30%/50%)
330,000
Notes:
● The P620,000 payment to C by A and B is not
recorded in the books.
● The capital balance of C is allocated to the
purchasing partners based on their relative old P/L
ratio. (Partner’s old P/L ratio divided by the sum of
remaining partner’s old P/L ratios, i.e., A’s 20% + B’s
30% = 50%).
Partnership Capital after C’s Withdrawal:
A
B
C
Total
Bal. before
withdrawal
330k
520k
550k
1,400k
Withdrawal of C
220k
330k
(550k)
Bal. after
withdrawal
550k
850k
1,400k
Notes:
● Total partnership capital remains at P1,400,000
before and after C’s withdrawal.
Case 2: Retirement - Settlement of Interest by
partnership
C retires on July 1, 20x1. The partnership settles C’’s
interest for P620,000 cash.
Requirement: Provide the journal entries.
●
The entry to record the retirement of C is as
follows:
July 1
C, Capital
550,000
A, Capital (620k - 550k) x 20%/50%) 28,000
B, Capital (620k - 550k) x 30%/50%) 42,000
Cash
620,000
Notes:
● C is given a bonus of P70,000 (P620,000 payment
- P550,000 capital balance). The bonus is
deducted from the capital balances of the
remaining partners.
● The payment to C is recorded in the books
because the interest of C is settled by the
partnership, rather than by the remaining partners.
Partnership Capital after C’s retirement:
A
B
C
Total
Adj. bal. before
retirement
330,000 520,000 550,000 1,400,000
Payment to C
(620,000) (620,000)
Bonus to C
(28,000) (42,000) 70,000
Bal. after
retirement
302,000 478,000
780,000
Note: The partnership capital is reduced by the P620,000
payment for C’s capital balance.
Comparison between purchase of interest by remaining
partners and settlement by the partnership:
Purchase by remaining
partners
Settlement by partnership
The
payment
to
the
outgoing partners is not
recorded
in
the
partnership’s books.
The
payment
to
outgoing
partner
recorded
in
partnership’s books.
Partnership capital remains
the same before and after
the withdrawal, retirement r
death of the outgoing
partner.
Partnership
capital
is
decreased by the payment
for the outgoing partner’s
capital balance.
No
gain
or loss is
recognized
in
the
partnership’s books.
No
gain
or loss is
recognized
in
the
partnership’s book.
the
is
the
Incorporation of a Partnership
Another instance that causes partnership dissolution
is the incorporation of a partnership. When a partnership is
converted into a corporation, the partners relation changes they cease to be partners (i.e., agents of the business) and
become stockholders.
There are various reasons for incorporating a
partnership, which may include the following:
a. Limited liability of shareholders - shareholders are not
liable to corporate creditors beyond their investment
in the corporation.
b. Ease of raising additional capital - greater capital can
be raised through an increased number of owners.
Also, it is easier for a corporation to generate external
financing, as lenders need not worry about the death
of the partners.
c. Privacy and confidentiality - unlike in partnerships, the
owners of a corporation are not agents of the
corporation.
d. Dispersion of risk - the risk of loss is dispersed to
more owners.
e. Unlimited life - changes in the relationship of the
owners.
f.
Transferability of ownership - ownership interest in a
corporation can be easily transferred through sale of
shares of stocks, and does not dissolve the
corporation.
g. Better public relations - many believe that wider
ownership of a business results in better public
relations.
When a partnership is converted into a corporation,
the corporation acquires the assets and assumes the liabilities
of the partnership and in return issues shares of stocks to the
owners. On date of incorporation:
a. The partners’ capital balances are adjusted for their
respective shares in any profit or loss and revaluation
gains or losses as at the date of incorporation. The
adjusted capital balances may be used to determine
the number of shares to be issued to each partner.
b. Normally, the books of the partnership are closed and
new books are opened for the corporation.