INTRODUCTION TO PARTNERSHIP ACCOUNTING

Partnership defined
The civil code defined partnership as a contract where two or more persons
bind themselves to contribute money, property, or industry to a common fund,
with the intention of dividing the profits among themselves. Two or more
persons may also form a partnership for the exercise of profession.

Basic considerations in forming a partnership

Characteristics of a partnership
The following are the characteristics of a partnership that differentiates it with
other form of business.
A. Voluntary association – the partnership is formed out of the consent of
all partners.
B. Ease of formation – the formation of a partnership requires less
formality and requirements as opposed to corporations.
C. Separate legal entity – a partnership is separate and distinct
from the owners. It has a judicial personality and that it can
transact and acquire properties in its name.
D. Mutual agency – the partners act as agents of the partnership.
Thus, the partners may legally bind the partnership to a
contract or agreement that is in accordance with the
partnership’s operations.
E. Joint ownership – each partner is a co-owner of the properties
invested in the partnership and each has an equal right with
his partners to possess specific partnership property for
partnership purposes.
F. Co-ownership of profits – each partner is entitled to his or her
share in the partnership’s profit. Based on the civil code, a
stipulation which excludes one or more partners from any
share in the profits or losses is void.
G. Limited life – since partnership is based on the consent of the
partners, a partnership may dissolved by any of the following:
 By the express will of any partner
 By the termination of a definite term stipulated in the contract
 By any event which makes it unlawful to carry out the partnership
 When a specific thing which a partner had promised to contribute to the
partnership perishes before the delivery, or
 Expulsion, death, insolvency or civil interdiction of a partner.
H. Unlimited liability – each partner, including industrial partners, are
personally liable for the partnership debt after all partnership assets have
been exhausted.

Kinds of partnership
General partnership – a partnership where all partners are individually liable
Limited partnership – a partnership where at least one partner is personally
liable. It includes at least one general partner who maintains unlimited
liability. Limited partners are liable only up to the extent of their contributions
to the partnership.
De facto partnership – a partnership that has not complied with all the legal
requirements of a partnership but may still be recognized as a partnership to
protect individuals you transacted in good faith.
De Jure partnership – a partnership that has complied with all legal
requirements of a partnership.

Kinds of partners
By Liability
Limited Partner – a partner who is liable only up to his or her contribution to
the partnership.
General Partner – a partner who is liable up to his or her personal assets if all
of the assets of the partnership has been extinguished.

By Activity
Active or managing partner – a partner who takes active interest in the
conduct and management of the business.
Dormant or sleeping partner – a partner who does not take active part in the
management of the business. Such partner only contributes to the share
capital of the firm, is bound by the activities of other partners, and shares the
profits and losses of the business.

Nominal or ostensible partner – a person who does not have any real
interest in the partnership but lends his name to the business, without any
capital contribution, and does not share in the profits of the
business. However, he is liable to outsiders as an actual partner.

Estoppel – a person, by word or conduct, holds out to another that he is a

partner. The person becomes liable to third parties as a holding out partner.
Secret Partner – a partner who is not known and does not want to disclose to
the general public of his relationship with the business.

By Contribution
Capitalist partner – a partner who contributed money or property to the
partnership.
Industrial partner – a partner who contributes industry or service to the
partnership.

Advantages and disadvantages of a partnership

Advantages of a partnership
1. Ease of formation
2. Shared responsibility of running the business
3. Flexibility in decision making
4. Greater capital compared to sole proprietorship
5. Relative lack of regulation by the government as compared to
corporations.

Disadvantage of a partnership
1. Easily dissolved or with limited life
2. Unlimited liability
3. Conflict among partners
4. Lesser capital compared to a corporation
5. A partnership (other than a general professional partnership) is taxed
like a corporation.

Partnership vs sole proprietorship

A sole proprietor is owned by a single person who has unlimited liability for the
business but solely owns the assets and profits of the business, a partnership
is owned by two or more person that gives it greater access to capital and
shared liability among the partners.

Partnership vs. Corporation

A partnership is based on the consent and voluntary association of the
partners. A change in ownership structure dissolves the partnership. On the
other hand, a corporation is owned by shareholders as represented by shares
of stocks. Ownership is transferred to sale of shares of stocks. Moreover,
corporation has greater access to capital as opposed to partnership and
shareholders are not liable for the corporation’s liabilities.

Accounting for partnership

The following are the major considerations in the accounting for the equity of a
partnership.
1. Formation – involves accounting for initial investments of partners to the
partnership
2. Operations – covers the division of profit or losses
3. Dissolution – includes the admission of a new partner, withdrawal,
retirement or death of a partner.
4. Liquidation – covers the winding up of affairs

Self-Assessment Activity:
1. Define Partnership
2. Cite the common characteristics of a partnerships.
Identify the different kinds of partnerships and partners.
PARTNERSHIP FORMATION
A contract is consensual and it is created by the agreement of partners,
whether oral or in written form. However, the Philippine Civil Code requires
that a partnership agreement must be in a public instrument and registered
with the Securities and Exchange Commission (SEC) when:
1. Immovable property or real rights are contributed to the partnership
2. The partnership has a capital of P3,000 or more.
Furthermore, the Civil Code requires that an inventory of any immovable
property contributed to the partnership should be made, signed by the parties,
and attached to the public instrument, otherwise the partnership shall be
deemed void.
Valuation of contribution
The assets and liabilities contributed to the partnership should be recorded at
agreed values if available, otherwise, at the fair market value at the date of the
formation of the partnership.
Fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date (PFRS 13).
Partners ledger accounts are:
1. Capital accounts
2. Drawing accounts
 3. Receivable from/Payable to a partner
Capital accounts are used to record initial investments, additional investment,
permanent withdrawals of capital, share in profits and losses, debit balance of
drawing accounts. The capital account has a credit normal balance.

Receivable from/Payable to a partner – These accounts are used to record

loan transactions between the partnership and a partner. A loan extended by
the partnership to a partner is a receivable from the partner while a loan
obtained by the partnership from a partner is accounted as a payable to the
partner.

In accounting for partnership formation, the total initial investment may either
equal to the amount credit to the capital or the amount credited the partner’s
capital may be different. If the contribution is not equal to capital interest, the
difference is accounted for under the bonus method or the goodwill method.

The use of either bonus method or goodwill method must be explicitly

stated in the problem. If not stated, the bonus method is preferred.

1. INDIVIDUALS FORM A PARTNERSHIP: Caramel, Macchiato and

Grande are to form a partnership for a coffee business. Caramel is to
contribute cash of P150,000 and his used imported coffee maker
originally bought at P160,000 but has a second hand value of
P100,000. Macchiato is to contribute cash of P200,000, and tables and
chairs with an appraised value of P40,000 but acquired by Macchiato for
only P36,000. Grande, whose family is selling blenders and steamer is
to contribute cash of P80,000 and a brand new blender and steamer
with regular price of P160,000 but which cost their family’s computer
dealership P140,000. Partner’s agree to share profits 3:2:3. How much
is the capital balance of Caramel, Macchiato and Grande, respectively
upon formation?

2. SOLE PROPRIETOR ADMITS PARTNERS: On June 30, 2014

Espresso, the sole proprietor of Espresso Inc, expands the company
and establishes a partnership with Caffé and Latté. The partners plan
to share profits and losses as follows: Espresso, 50%; Caffé, 25% and
 Latté 25%. They also agree that the beginning capital balances of
partnership will reflect this same relationship.

Espresso asked Caffé to join the partnership because his many business
contacts are expected to be valuable during the expansion. Caffé is also
contributing P40,000 and a building that has an original cost of P520,000,
book value of P420,000, tax assessment of P310,000 and fair value of
P370,000. The building is subject to a P242,000 mortgage that the
partnership will assume. Latté is contributing P66,000 cash and marketable
securities costing P252,000 but are currently worth P345,000.

Espresso’s investment in the partnership is his business. He plans to pay off

the notes with his personal assets. The other partners have agreed that the
partnership will assume the accounts payable. The balance sheet for the
Espresso Incorporated is as follows:
Balance Sheet
June 30, 2014
Assets Liabilities and Capital
Cash P60,000 Accounts payable P318,000
Accounts receivable (net) 288,000 Notes payable 372,000
Inventory 432,000 Espresso, Capital 510,000
Equipment-net(dept’n,
420,000
P120k)

The partners agree that the inventory is worth P510,000, and the equipment is
worth half its original cost, and the allowance established for doubtful
accounts is correct.

Required:
1. How much is the agreed capital of Espresso if the partners agree to use
the bonus method to record the formation.
2. How much is the agreed capital of Espresso if the partners agree to use
the goodwill approach to record the formation?

3. INDIVIDUALS FORM A PARTNERESHIP: Darren and JK formed a

partnership by contributing the following assets:
 DARREN JK
Cash P170,000
Land - P220,000
Building - 320,000
Equipment 100,000

It was agreed that the equipment shall be valued at P120,000. The land has
an appraised value of P220,000 but is agreed to be taken at its zonal value of
P200,000. The land and building is subject to a P100,000 real estate
mortgage which is assumed by the partnership. The mortgage also has an
accrued interest of P10,000 is to be assumed by JK. Included in the cash
balance are highly liquid investments booked at P40,000 but with current fair
value of P50,000. Darren and JK shall share in profits 50:50.
Required: Compute for the initial capital if Darren and JK agreed to share in
the capital 40:60, respectively.
1. Bonus method (indirect approach)
2. Goodwill method (indirect approach)
3. No revaluation and bonus method
4. Personal cash settlement
5. Settlement by cash investment
6. Settlement by cash withdrawal

4. INDIVIDUALS FORMING A PARTNERSHIP: Hazelnut and Vanilla

decided to form a partnership on June 1, 2014. The partnership will
take over their assets as well as assume their liabilities. As of June 1,
2014, the net assets of Hazelnut and Vanilla are P220,000 and
P309,375 each respectively. Liabilities of Hazelnut are 55% less than
the book value of its net assets while liabilities of Vanilla are 40% more
than the book value of its net assets. The partners agreed on a 25:75
profit and loss ratio. Furthermore, the partners arrived on the following
agreements: Hazelnut’s inventory is undervalued by P11,000; an
allowance for doubtful accounts is to be set up in the books of Hazelnut
and Vanilla at 10% of the accounts receivable balances (Hazelnut,
P27,500; Vanilla, P41,250). Accrued salary of P20,250 was not
recognized in Vanilla’s books.

Required:
What is total assets of the partnership immediately after formation if partner’s
capital interest should be equal to their profit and loss ratio through withdrawal
or additional investment with Vanilla’s capital to be used as the basis?

5. SOLE PROPRIETORS FORMING A PARTNERSHIP: Lyca and Darleen

decided to form a partnership on August 1, 2014. Their statements of
financial position on this date are:

Lyca Darleen
Cash 65,625.00 164,062.50
Accounts Receivable 1,487,500.00 896,875.00
Merchandise
875,000.00 885,937.50
Inventory
Equipment 656,250.00 1,268,750.00
Total 3,084,375.00 3,215,625.00

Accounts Payable 459,375.00 1,159,375.00

Lyca, Capital 2,625,000.00
Darleen, Capital 2,056,250.00
Total 3,084,375.00 3,215,625.00

They agreed to have the following adjustments:

 Equipment of Lyca is under-depreciated by P87,500 and that Darleen is
over depreciated by P131,250.
 Allowance for doubtful accounts is to be set up amounting to P297,500
for Lyca and P196,875 for Darleen.
 Inventories of P21,875 and P15,312.50 are worthless in Lyca and
Darleen’s books respectively.
 The partnership agreement provides for a profit and loss ratio equally
and capital interest of 70% to Lyca and 30% to Darleen.

Required:
1. Using the transfer of capital method, how much is Lyca’s capital to bring
the capital balances proportionate to their profit and loss ratio?
 2. Using the transfer of capital method, how much is to be debited to
Darleen’s capital account to bring the capital balances proportionate to
their profit and loss ratio?
3. Using the invest/withdraw cash method, how much cash should Lyca
invest or withdraw to bring the capital balances proportionate to their
profit and loss ratio?

6. On June 30, 20x10 MOC, the sole proprietor of MOC Inc, expands the
company and establishes a partnership with CBC and GKR. The
partners plan to share profits and losses as follows: MOC, 50%; CBC,
25% and GKR 25%. They also agree that the beginning capital
balances of partnership will reflect this same relationship.
DISTRIBUTION OF PARTNERSHIP PROFIT OR LOSS
Accounting for partnership operations is similar to accounting for a sole
proprietorship, except for the computation and distribution of profit and
losses. With several partners, profit and losses are computed based on the
agreement of partnership before it is distributed to the partners.
As provided by the partnership law, the losses and profits shall be distributed
in conformity with the partnership’s agreement. If only the share of each
partner in the profits has been agreed upon, the share of each in the losses
shall be in the same proportion (Article 1797).
In the absence of stipulation, the share of each partner in the profits and
losses shall be in proportion to what he may have contributed, but the
industrial partner shall not be liable for the losses. As for the profits, the
industrial partner shall receive such share as may be just and equitable under
the circumstances. If besides his services he has contributed capital, he shall
also receive a share in the profits in proportion to his capital. (1689a)
The partners may provide other stipulation regarding the distribution of profits
or losses as follows:
1. Interest on capital contributions– Capitalist partners may receive interest
on their capital balances to compensate for the differences in the
amount of capital contributed. Interest may be based on original capital,
beginning capital, year-end capital or weighted average.
2. Salary – This is to even out the differences in the time and skills
contributed by partners in the management of the partnership. This
usually received by an industrial partner.
3. Bonus – The partners may provide bonus to managing partners for
excellent management performance. A partner is entitled to bonus only
if the partnership generated a profit. Bonus is not given when the
partnership incurs a loss. This may be computed based on net income
 before bonus, or net income after bonus but before taxes, or based on
net income after bonus and after taxes.
Interests and salaries are guaranteed provisions. Meaning, interests and
salaries are distributed to partners whether the partnership incurs a gain or a
loss. On the other hand, bonus is not provided when the partnership incurs
a loss.
The interest on capital contribution, salary and bonus are provided first to the
respective partners. Any remaining profit or loss is shared based on their
stipulated profit or loss ratio.
Illustrative Problem 1
The partnership of A, B, and C stipulates the following:
 Partners A and C shall receive annual salaries of P12,000 and P8,000,
respectively.
 A bonus of 10% of profit after salaries but before deduction of bonus
shall be given to Partner A, the managing partner.
 Each partner shall receive 10% interest on average capital investments.
 Any remaining profit or loss shall be shared as follows: 40% to A and
30% each to B and C.
The average capital investments of partners during the year are as follows:
A P100,000
B 60,000
C 120,000

Required: Compute for the respective shares of the partners on the

partnership profit or loss under the following independent cases.
Case 1: The partnership earns profit of P100,000.
Case 2: The partnership earns profit of P10,000.
Case 3: The partnership incurs loss of P20,000.

DISTRIBUTION OF PARTNERSHIP PROFIT OR LOSS

Accounting for partnership operations is similar to accounting for a sole
proprietorship, except for the computation and distribution of profit and
losses. With several partners, profit and losses are computed based on the
agreement of partnership before it is distributed to the partners.
As provided by the partnership law, the losses and profits shall be distributed
in conformity with the partnership’s agreement. If only the share of each
partner in the profits has been agreed upon, the share of each in the losses
shall be in the same proportion (Article 1797).
In the absence of stipulation, the share of each partner in the profits and
losses shall be in proportion to what he may have contributed, but the
industrial partner shall not be liable for the losses. As for the profits, the
industrial partner shall receive such share as may be just and equitable under
the circumstances. If besides his services he has contributed capital, he shall
also receive a share in the profits in proportion to his capital. (1689a)
The partners may provide other stipulation regarding the distribution of profits
or losses as follows:
1. Interest on capital contributions– Capitalist partners may receive interest
on their capital balances to compensate for the differences in the
amount of capital contributed. Interest may be based on original capital,
beginning capital, year-end capital or weighted average.
2. Salary – This is to even out the differences in the time and skills
contributed by partners in the management of the partnership. This
usually received by an industrial partner.
3. Bonus – The partners may provide bonus to managing partners for
excellent management performance. A partner is entitled to bonus only
if the partnership generated a profit. Bonus is not given when the
partnership incurs a loss. This may be computed based on net income
before bonus, or net income after bonus but before taxes, or based on
net income after bonus and after taxes.
Interests and salaries are guaranteed provisions. Meaning, interests and
salaries are distributed to partners whether the partnership incurs a gain or a
loss. On the other hand, bonus is not provided when the partnership incurs
a loss.
The interest on capital contribution, salary and bonus are provided first to the
respective partners. Any remaining profit or loss is shared based on their
stipulated profit or loss ratio.
Illustrative Problem 1
The partnership of A, B, and C stipulates the following:
 Partners A and C shall receive annual salaries of P12,000 and P8,000,
respectively.
 A bonus of 10% of profit after salaries but before deduction of bonus
shall be given to Partner A, the managing partner.
  Each partner shall receive 10% interest on average capital investments.
 Any remaining profit or loss shall be shared as follows: 40% to A and
30% each to B and C.
The average capital investments of partners during the year are as follows:
A P100,000
B 60,000
C 120,000

Required: Compute for the respective shares of the partners on the

partnership profit or loss under the following independent cases.
Case 1: The partnership earns profit of P100,000.
Case 2: The partnership earns profit of P10,000.
Case 3: The partnership incurs loss of P20,000.

PARTNERSHIP DISSOLUTION

The partnership law of the civil code of the Philippines defined dissolution as
the change in the relationship of the partners caused by any partner ceasing
to be associated in the carrying out of the business.

Hence, any change in the relationship between or among partners will result
in the partnership’s dissolution.

The following are changes in the ownership structure that results in

partnership dissolution:
1. Admission of a new partner
2. Retirement, withdrawal or death of a partner
3. Incorporation of a partnership

Assignment of interest to a third party does not result to partnership

dissolution.
ADMISSION OF A NEW PARTNER
A new partner may be admitted by investment in the
partnership or purchase of interest from existing partner/s.

Investment of new partner in the partnership

If the new partner invests in the partnership, the invested asset is valued at
agreed value or fair market value. If the capital of the new partner is equal to
the net assets invested, there is no accounting issue. However, if the new
partner’s capital is not equal to the net assets invested, it may either
accounted under the bonus method or goodwill method or a possible
revaluation of assets.

Under the bonus method if the new partner’s capital balance is greater than
the investment, there is bonus to new partner from the old partners. If the
capital balance is less than the investment, there is bonus to the old partners
from the new partner.

In the bonus method, the total contributed capital is always equal to the total
agreed capital.

If the partners’ records the admission under the goodwill method, the total
agreed capital is more than the contributed capital since goodwill, an asset is
to be recognized.

Purchase of interest from old partners

Purchase of interest from partner/s is a transaction between partners. No
additional asset is invested and hence only a transfer of capital from the
selling partner to the new partner is recorded unless goodwill is to be
recognized.

Any difference in the purchase price and the capital interest of the new partner
is a personal gain or loss of the partners.

The partners may revalue assets prior to admission by purchase. The

revaluation may result in the increase of the value of assets (positive asset
revaluation) or decrease the value of assets (negative asset revaluation).
The decreases or increases in asset/s are adjusted to the capital of the old
partners based on their profit and loss ratio.

SHAREHOLDERS' EQUITY
The term equity maybe used for all business organizations. For a single
proprietorship, the claim of the owners against the assets is called the capital
or the owner’s equity. For a partnership, the partners’ claim against the assets
is called partners’ capital or partners’ equity. In a corporation, the claims of its
owners are called the shareholders’ equity. Instead of maintaining separate
capital and drawing accounts for each shareholder, the interest of the owners
of a corporation is accounted for according to source, classified into two main
sources; that is, contributed capital or paid in capital and earned capital or
accumulated profits. There is no basic difference in accounting for the
transactions of a sole proprietorship, a partnership or a corporation, except
where the owners’ equity accounts are involved.

CONCEPT OF A CORPORATION

Section 2 of Batas Pambansa 68, also known as the Corporation Code of the
Philippines defines “A corporation is an artificial being, created by operation of
law, having the right of succession and the powers, attributes and properties
expressly authorized by law or incident to its existence.”
A private corporation is an artificial person. It is a legal or juridical person with
a personality separate and apart from its individual members or
shareholders. The contractual rights and obligations of a corporation and of
its shareholders are separate and distinct. The right to be and to act as a
corporation is not a natural or civil right, but a franchise requiring special
authority from the state, thus a corporation is generally created by operation of
law (approval of the Securities and Exchange Commission). A corporation
cannot be created by mere agreement of the parties.
With the right of succession, a corporation can continue to operate up to the
period stated in its charter but not to exceed fifty years. Its rights and powers
are not inherent, but are strictly dependent upon the general and special laws,
which authorizes its creation, and in particular upon the terms of its own
charter. The powers of a corporation are those expressly granted and those
which are necessarily incidental thereto.

Components of a Corporation
 1. Incorporators – these are the shareholders or members mentioned in
the articles of incorporation as originally forming and composing the
corporation. They must be natural persons. The Corporation Code of
the Philippines specifies that five or more persons, not exceeding
fifteen, may form a private corporation provided they are of legal age,
owners or subscribers to at least one share of capital and that the
majority are residents of the Philippines.
2. Corporators – they are the shareholders or members who compose the
corporation. A partnership or corporation can be a corporator but not an
incorporator. All incorporators are corporators but not all corporators
are incorporators. The shareholders or members compose the
corporation but they are not the corporators.
3. Shareholders – these are the owners of shares of a stock corporation.
4. Members – these are the corporators of a corporation with no share
capital or a non-stock corporation.
5. Subscribers – these are the persons who have agreed to take and pay
for original, unissued shares of a corporation but will pay their
subscriptions at a later date. They eventually become shareholders
when their subscriptions are fully paid for and share certificates are
issued.
6. Promoter – is one who alone or with others undertakes to form a
corporation and to produce for it the rights, instrumentalities and capital
by which it is to carry out the purposes set forth in its charter, and to
establish it as fully able to do its business.

Corporate Books and Records

1. Minute books – this contains the minutes of the meetings of the
directors and shareholders. It may also contain a copy of the by-laws.
2. Stock and transfer book – this is a record of all names of the
shareholders or members alphabetically arranged; instalments paid on
all shares, date of payments, alienations, sales or transfers of shares,
the dates thereof, to whom made, and all other entries as prescribed by
the by laws. It shall be kept in the principal office of the corporation and
shall be opened for the inspection of any director, shareholder or
members of the corporation at reasonable hours.
3. Records of all business transactions – these include all accounting
records including journals, ledgers, and other business records such as
the shareholders’ ledger. The shareholders’ ledger is a subsidiary ledger
to the share capital account.
4. Subscription book – is a book of printed blank subscription.
 5. Shareholders’ ledger – a subsidiary for the share capital issued
reporting the number of shares issued to each shareholder.
6. Subscribers’ ledger – is a subsidiary for the subscription receivable
account reporting the individual subscription of the subscribers.
7. Share certificate book – is a book of printed blank share certificates.

Preincorporation subscription requirement

The Corporation Code provides that the SEC shall not register any stock
corporation unless 25% of its authorized number of shares has been
subscribed, and at least 25% of the subscription has been paid. In no case;
however, shall the paid in capital be less than P5,000.

COMPONENTS OF SHAREHOLDERS’ EQUITY

The shareholders’ equity is the residual interest of the owners in the net
assets of a corporation measured by the excess of assets over
liabilities. Generally, the components of the shareholders’ equity are:

1. Share capital – it is the portion of the paid-in capital representing the

total par preference share is listed first, followed by ordinary share.
2. Subscribed share capital less subscription receivable

Subscribed share capital is the portion of the authorized share capital that
has been subscribed but not fully paid and therefore still unissued. It is
recorded at par or stated value of the shares subscribed.
Subscription receivable represents the amount collectible from
subscribers of share capital. It is shown as a deduction from the related
subscribed share capital. However, subscriptions receivable collectible within
a year should be shown as a current asset. Generally, subscriptions
receivable is current in nature.

3. Share premium – represents the capital contributed by the

shareholders in excess of the par or stated value of the share
subscribed and issued. The common sources of share premium include
excess over par value or state value, resale of treasury shares at more
than cost, donated capital, issuance of detachable share warrants,
distribution of stock dividends, quasi reorganization and recapitalization.
 4. Accumulated profits and losses – it represents the cumulative
balance of periodic earnings, dividend distributions, fundamental errors
and other capital adjustments.
5. Revaluation reserve – it represents the excess of sound value over the
net book value. Sound value is computed by deducting observed
depreciation from appraised value. Net book value is computed by
deducting accumulated depreciation on cost from historical cost.
6. Treasury share – it represents the corporation’s own shares that have
been issued and then reacquired but not cancelled. The total cost of
treasury shares should be shown as deduction from the total
shareholders’ equity.

LEGAL CAPITAL
Legal capital is that portion of the paid in capital arising from the issuance of
share capital which cannot be returned to the shareholders in any form during
the lifetime of the corporation. The amount of legal capital is determined as
follows:

1. In the case of par value shares, legal capital is the aggregate par value
of all shares issued and subscribed.
2. In the case of no par value shares, legal capital is the total consideration
received from shareholders including the excess over stated value.

TRUST FUND DOCTRINE

The trust fund doctrine holds that the share capital of a corporation is
considered a trust fund for the protection of creditors. Thus, it is illegal to
return such legal capital to shareholders during the lifetime of the
corporation. However, the corporation can pay dividends to its shareholders
but limited only up to the balance of the unappropriated accumulated profits.
Thus, if an entity has a deficit, it is illegal to pay dividends.

ACCOUNTING FOR SHARE CAPITAL

There are two methods of recording share capital transactions.

1. Memorandum method – Only a memorandum is made for the total
authorized share capital. The share capital account is credited when
share capital is issued.
 2. Journal entry method – The authorization to issue share capital is
recorded by debiting unissued share capital and crediting authorized
share capital. When share capital is issued, it is credited to the unissued
share capital account.

The memorandum method will be used in the illustrations in this

chapter.

The sequence of share capital transactions involves the following:

1. Authorization
2. Issuance of share capital
3. Subscription
4. Collection
5. Issuance of share certificates.

AUTHORIZATION

The authorization for the corporation to issue shares of stocks is set forth in
the Articles of Incorporation. The obtaining of authorization for stock issue
merely affords a legal opportunity to obtain assets thru the sale of stocks. The
authorization should indicate the following:

1. The class or classes of stocks the corporation is authorized to issue;

2. The number of shares it is authorized to issue and the par value of the
stock;
3. In case of true no par value shares, the total of authorized capital should
be indicated.

ILLUSTRATION
X company received an authorization from the SEC to issue 40,000 shares
with par value of P100.

Memorandum method (Memo Entry)

“X company is authorized to issue 40,000 shares with par value P100 for a
total capital of P4,000,000.”

Journal entry method

The entry to record authorization to issue 40,000 shares with a par value of
P100 is as follows:

Unissued share capital 4,000,000

Authorized share capital 4,000,000

ISSUANCE OF SHARE CAPITAL

Issuance of shares for cash

Most shares issues are for cash since the primary reason why an entity sells
shares is to raise capital for the company’s operating activities. Shares can
be issued at par value, above par value and less than par value. When no par
value shares are issued, it cannot be issued for less than P5. In the
Philippines, no par value shares must have a stated value of not less than P5.

1. Issuance at par value. When shares are sold for cash at par value, the
entry is a debit to cash and a credit to share capital. If a company
issues 2,000 shares at its par value P100, the entry is:

Cash (2,000sh x P100) 200,000

Share capital 200,000

1. Issuance at more than par value. When shares are sold at a price
more than its par value, the entry is a debit to cash for the proceeds,
and a credit to share capital to the extent of the par value and the
excess being credited to share premium. If a company issues 2,000
shares with par value P100 for P110, the entry is:

Cash (2,000sh x P110) 220,000

Share capital 200,000
Share Premium [(P110-P100) x
20,000
2,000 sh]
 1. Issuance at less than par value. When shares are sold at a price less
than its par value, they are said to be issued at a discount. The
Corporation Code prohibits the issue of a share at a discount. The
discount is not considered a loss but a liability of the shareholder. Note
that the issued itself is not void, but the agreement that the share shall
be paid less than its par value is illegal and cannot be enforced. The
issue of the share is therefore not cancelled but the shareholder must
pay for the discount. This is called the discount liability of the
shareholder and is accounted for separately. If a company issues 2,000
shares with par value P100 for P98, the entry is:

Cash (2,000sh x P98) 196,000

Discount on share capital [(P100-
4,000
P98)x2,000sh]
Share capital 200,000

Note: Share capital account, such as ordinary share capital and preference
share capital is always recognized at par value. Whatever the difference from
issuing price and par value would be recognized as premium if the issuance is
higher than par value or discount, if the issuance is less than par value.

Issuance of shares for noncash assets and services

This is considered a nonmonetary exchange. Based on PFRS 2, equity
settled share-Based Payment, the entity shall measure the goods or services
and the corresponding increase in equity directly at the fair value of the goods
and services received unless the fair value cannot be estimated reliably. If the
entity cannot estimate the fair value of the goods and services received, the
entity shall measure their value and the corresponding increase in equity,
indirectly by reference to the fair value of the equity instruments issued.

If share capital is issued for noncash consideration, the share capital is

recorded at an amount equal to the following in the order of priority:

1. Fair value of the noncash consideration received

2. Fair value of the shares issued
3. Par value of the shares issued
ILLUSTRATION
On March 1, 2014, Mayon Company issued 15,000 shares of its P100 par
ordinary shares in acquiring a land that was recently appraised at
P1,700,000. The ordinary share is actively selling at P120 per share. The
entry to record this transaction is:

Land (15,000sh x P120) 1,800,000

Ordinary share capital (15,000sh x
1,500,000
P100)
Share Premium 300,000

Share issuance costs

These are direct costs to sell share capital which normally include registration
fees, underwriter commissions, legal fees, accounting fees, share certification
costs, promotional costs and postage, filing fees with SEC, documentary
stamps. PAS 32, paragraph 37, provides that transaction costs that are
directly attributable to the issuance of new shares shall be deducted from
equity, net of tax. The share issuance costs shall be debited to share
premium arising from the issuance. If the share premium is insufficient to
absorb such expenses, the Philippine Interpretations Committee (PIC) states
that the excess shall be debited to share issuance costs as a contra equity
account deducted from the following in the order of priority:

1. Share premium from previous share issuance

2. Accumulated profits

Costs of public offering of shares

The PIC concluded that costs that relate to stock market listing, or otherwise
are not incremental costs directly attributable to the issuance of new shares,
shall be recorded as expense in the Income Statement. The cost of listing
shares are not considered as costs of an “equity transaction” since no equity
instrument has been issued, thus expensed immediately. Examples of these
costs are road show presentation and public relations consultant’s fees.

Joint costs
PAS 32, paragraph 38, requires that transaction costs that relate jointly to the
concurrent listing and issuance of new shares and listing of old existing
shares shall be allocated between the newly issued and listed shares, and the
newly listed old existing shares. Since PAS 32 does not give further
guidelines as to the basis of allocation, the PIC concluded that joint costs shall
be allocated prorate on the basis of the outstanding newly issued and listed
shares and outstanding listed old existing shares. Examples of joint costs are
audit and other professional advice relating to the prospectus, tax opinion,
opinion of counsel, fairness opinion and valuation report and prospectus
design and printing.

ILLUSTRATION
Eden Company undertakes an initial public offering for the listing and
issuance of 70,000 new shares and the listing of 30,000 existing shares. The
company incurred the following costs: Documentary stamp tax – P 25,000;
Fairness opinion and valuation report – P125,000; Tax opinion – P100,000;
Newspaper publication – P200,000; Listing fee – P300,000; Other joint costs –
P275,000.

1. The cost of public offering is expensed immediately, thus the entry is:

Stock listing fee 300,000

Cash 300,000

1. The share issuance costs shall be recorded as follows:

1. If the new shares are issued at more than par:

Share premium 225,000

Cash 225,000
Computation:
Doc stamp tax P 25,000
Newspaper publication 200,000
Total P 225,000

2. If the new shares are issued at par:

Share issuance costs 225,000

 Cash 225,000

Note: Share issuance costs shall be reported in the Statement of Financial

Position as a contra equity account deducted from the following:
1. Share premium from previous share issuance
2. Accumulated profits

1. The entry to record the joint costs is:

Share premium 350,000

Stock listing fee 150,000
Cash 500,000

The joint costs are allocated as ff.

Shares Fraction Allocated Amount
Newly issued 70,000 sh 7/10 P 350,000
Newly listed existing
30,000 3/10 150,000
shares
100,000 sh P 500,000

Watered shares
These are shares issued for inadequate or insufficient consideration. The
consideration received is less that par or stated value, but the share capital is
issued as fully paid. Thus, assets are overstated and capital is overstated.

ILLUSTRATION
A land with fair value of P700,000 is received for 10,000 shares of P100 par
value. The issuance is recorded as fully paid as follows:

Land 1,000,000
Share capital 1,000,000
Observe that the land is overstated and share capital is also overstated. The
issuance of shares at less than its par value is illegal. The shareholder has a
discount of P300,000. To correct the accounts, the entry is:

Discount on share capital 300,000

Land 300,000

Secret reserve
This arises when asset is understated or liability overstated with a consequent
understatement of capital. Secret reserve usually arises from the following:

1. Excessive provision for depreciation, depletion, amortization and

doubtful accounts.
2. Excessive writedown of receivables, inventories and investments.
3. Capital expenditures are recorded as outright expenses.
4. Fictitious liabilities are recorded.

ACCOUNTING FOR SHARE SUBSCRIPTIONS

When shares are sold to the shareholders on an installment plan or
subscription basis, the investor signs a purchase agreement called a share
subscription contract and the buyer shall be referred to as the subscriber. A
subscription for shares of a corporation still to be formed shall be irrevocable
for a period of at least six months from the date of subscription, unless all the
other subscribers consent to the revocation, or unless the incorporation of
said corporation fails to materialize within the said period or within a longer
period as may be stipulated in the contract of subscription; provided, that no
pre incorporation subscription maybe revoked after the submission of the
articles of incorporation to the SEC.
The account Subscriptions receivable is debited when the subscription is
received and credited upon the collection of the subscription. Any balance in
the Subscription receivable at the end of the year is shown as a reduction
from the related Subscribed Share Capital account. However, if the
subscription is collectible within a year, it is classified as a current asset on the
Statement of Financial Position. Generally, subscriptions are collectible within
a year, thus classified as a current asset.
Since shares are not issued until the subscriptions are fully paid, a temporary
account, Subscribed share capital, is used and is recorded at par value or
stated value. This account is credited at the time the subscription is received
and is debited when final payment is received. Any balance of the Subscribed
share capital account at the end of the year is included in the paid in section
of the shareholders’ equity section of the Statement of Financial Position.

ILLUSTRATION
Pinatubo Corporation receives on August 1, 2014 subscriptions to 2,000
ordinary shares with par value P80 at P90 per share. A 50% down payment is
received and the balance in two equal instalment payments on September 1
and October 1, 2014. The entries are:

On August 1, 2014, the entry to record subscription of 2,000 share is as

follows:

Cash (2,000 sh. x P90 x 50%) 90,000

Subscriptions receivable – ordinary 90,000
Subscribed ordinary share
160,000
capital
Share premium-ordinary 20,000

On September 1, 2014 the entry to record partial collection is as follows:

Cash (P90,000/2) 45,000

Subscription receivable -
45,000
ordinary

On October 1, 2014 the entry to record the full payment and issuance of 2,000
ordinary share is as follows:

Cash 45,000
Subscribed ordinary share capital 160,000
Subscriptions receivable –
45,000
ordinary
Ordinary share capital 160,000
Default on Subscriptions
The Corporation Code provides that the board of directors may at any time
declare due and payable unpaid subscriptions. The official declaration is
known as a call usually expressed in the form of a board resolution stating the
date fixed for payment of the unpaid subscriptions. When a subscriber fails to
pay all or part of his subscriptions, then it is said to be in default and the
subscriber is said to be delinquent. Depending on the provisions of the
contract, the following possible scenarios can happen: (a) shares are offered
in an auction; (b) the entire amount collected is returned to the defaulting
subscriber; (c) the entire amount collected is returned to the defaulting
subscribed less any costs incurred by the corporation in reissuing the
shares; (d) a corresponding number of shares is issued to the defaulting
subscriber based upon the total amount collected; or (e) the entire amount
collected is forfeited.
When shares are offered in an auction, the delinquent shares are sold to the
“highest bidder”, the person who is willing to pay the “offer price” for the
smallest number of shares. The offer price shall include the unpaid
subscription, accrued interest, advertising expense and other costs incurred in
the sale. In case there are no bidders during the public auction, the
corporation may purchase the delinquent shares for itself and record it as
Treasury shares.

ILLUSTRATION
Mr. Why subscribed to 1,000 shares at par value P100, paying 30% down
payment. The balance was called and Mr. Why failed to pay, thus the
subscription was declared delinquent. Expenses incurred in connection with
the auction was P3,000. There were 3 bidders who were willing to pay the
offer price, namely: Ms. Ace who bidded for 800 shares; Ms. Bee for 820
shares; and Ms. Cee for 810 shares. The entries for the above transactions
are:

1. Subscriptions to 1,000 shares at par P100.

Cash (2,000sh x P100 x 30%) 30,000

Subscription receivable (P100,000 x
70,000
70%)
Subscribed share capital 100,000
 2. The balance was called and Mr. Why defaults.

No entry.

3. Expenses in connection with the auction of P3,000 was paid.

Advance on delinquency sale 3,000

Cash 3,000

4. Ms. Ace, the highest bidder, pays the offer price (unpaid balance of
P70,000 plus expenses of P3,000).

Cash 73,000
Advances on delinquency sale 3,000
Subscriptions receivable 70,000

5. Issuance of shares. (Mr. Why: 200 shares, Ms. Ace: 800 shares)

Subscribed share capital 100,000

Share capital 100,000

ADDITIONAL ASSUMPTION
Suppose there are no bidders? In such a case, the corporation may bid in the
absence of bidders. The entries would be:

The entry to record the purchase of delinquent shares of Mr. Why. Is as

follows:

Treasury shares 73,000

Advances on delinquency sale 3,000
Subscriptions receivable 70,000

The entry to record issuance of shares is as follows:

Subscribed share capital 100,000
Share capital 100,000

TREASURY SHARES

A treasury share is the corporation’s own share which has been issued and
reacquired by the issuing corporation but not for cancellation. Based on this
definition, there are four requisites for a share to be classified as treasury
share.
1. It must be the corporation’s own stock. The acquisition of shares of
other corporations is recorded as an investment.
2. It must have been issued originally. A treasury share can be legally
reissued at an amount less than its cost without any discount liability.
3. It is reacquired by the corporation in its name. The owner of the
reacquired shares is the corporation itself. Thus, treasury shares are
not entitled to receive dividends.
4. The reacquisition must not be for cancellation. If it is for cancellation
then it is called retired shares. Reasons for reacquiring treasury shares
include among others the following: (a) future source of funds; (b) for
distribution to employees in lieu of other compensation; and (c) to
bolster a sagging market of stock.

LEGAL LIMITATION ON TREASURY SHARES

The Corporation Code provides that “no corporation shall redeem,

repurchase, or reacquire its own shares, of whatever class, unless it has
adequate amount of unrestricted accumulated profits to support the cost of
said shares.” Thus, the corporation can acquire treasury shares only to the
extent of unappropriated accumulated profits. Purchasing treasury shares
with no restriction on the accumulated profits would be tantamount to
indirectly returning capital to shareholders, which is a violation of the trust fund
doctrine. Thus, in order to preserve the legal capital, the accumulated profits
must be appropriated to the extent of the cost of treasury shares and the
same must not be declared as dividend until the treasury shares is
subsequently sold. Treasury shares do not also have the right to vote or to
receive assets upon liquidation.
ACCOUNTING FOR TREASURY SHARES

PAS 32 recognizes only one method of accounting for treasury shares; that is,
the COST METHOD. Treasury shares should be recorded at cost, regardless
of whether the shares are acquired below or above par value or stated
value. If the treasury shares are acquired for cash, the cost is equal to the
cash payment. If the treasury shares are acquired for noncash consideration,
the cost is usually measured by the recorded amount or book value of the
noncash asset surrendered.

Repurchase of treasury shares To illustrate: Mayon Corporation reacquired

500 shares with par value P100 at P150 per share. The entry are as follows:

Treasury shares ( 500 sh x P150) 75,000

Cash 75,000

Accumulated profits 75,000

Appropriated for treasury shares 75,000

Sale of treasury shares

When treasury shares are reissued at cost, the entry include a debit to cash
and a credit to treasury shares at cost. If treasury shares are reissued at
more than cost, the excess of the reissue price over the cost is treated as
share premium. When treasury shares are reissued at less than cost, the
excess of cost over the reissue price is charged to the following in the order
mentioned: (a) Share premium from treasury shares of the same class until
balance is exhausted; (b) Accumulated profits. In the reissuance of treasury
shares, the FIFO method is used in costing such.

ILLUSTRATION
In the preceding illustration, assume that Mayon Corporation reissues 100
treasury shares at P160 per share and another 150 shares at P120. The
entries are as follows:
The entry to record the reissuance of 100 treasury shares at P160 is as
follows:

Cash (100 sh. x P160) 16,000

Treasury shares (100 sh x
15,000
P150)
Share premium – treasury shares 1,000

Appropriated for treasury shares 15,000

Accumulated profits 15,000

The entry to record the reissuance of 150 treasury shares at P120 is as

follows:

Cash (100 sh x P120) 18,000

Share premium – treasury shares 1,000
Accumulated profits 3,500
Treasury shares (150 sh x P150) 22,500

Appropriated for treasury shares 22,500

Accumulated profits 22,500

Retirement of treasury shares

If treasury shares are subsequently retired, the share capital account is

debited at par or stated value and the treasury shares are credited at cost. If
the treasury shares are retired at an amount less than its par, the excess of
the par value over the cost of the treasury shares is considered a “gain” and is
credited to Share premium from treasury shares. If the treasury shares are
retired at an amount more than its par, the difference of the cost of the
treasury shares over its par value is considered a “loss” and is debited to the
following in the order given:
1. Share premium to the extent of the credit when the shares were
originally issued (pro-rated with the number of shares retired)
 2. Share premium from treasury shares up to the extent of its balance
3. Accumulated profits

ILLUSTRATIONS
Case A: Retirement below par value
If 200 treasury shares with par value P100 are held in treasury at a cost of
P18,000 are subsequently retired, the entry are as follows:

Ordinary share capital (200 sh x P100) 20,000

Treasury shares 18,000
Share premium - treasury shares 2,000

Appropriated for treasury shares 18,000

Accumulated profits 18,000

Case B: Retirement Above par value

Ordinary share capital, 5,000 share authorized, P100 par,

150,000
1,500 shares issued and outstanding
Share premium - ordinary share capita 15,000
Share premium - treasury shares 13,000
Appropriated for treasury shares 40,000
Accumulated profits 70,000
Treasury shares, at cost, 200 shares 40,000

The entry to record retirement of treasury shares is as follows:

Ordinary share capital (200 sh x P100) 20,000

Share premium- ordinary share capital (15,000 x
2,000
200/1,500)
Share premium- treasury share 13,000
Accumulated profits 5,000
Treasury shares 40,000

Appropriated for treasury shares 40,000

Accumulated profits 40,000

Disclosure of treasury shares

The disclosure relating to treasury shares in the Statement of Financial
Position should include the following information:
1. The number of shares held in the treasury;
2. The restriction on the availability of accumulated profits for distribution
of dividends.

PAS 32, paragraph 33 provides that the cost of the treasury shares shall be
deducted from total shareholders’ equity.

DONATED SHARES

Donated shares are shares received from the shareholders by an entity by

way of donation. They are in essence treasury shares and thus be reissued
at any price without any discount liability. Since donated shares are acquired
without any cost, the assets, liabilities and shareholders’ equity are not
affected but the number of outstanding shares is reduced. The resale of
donated shares increases assets and donated capital. Donated capital
account is part of share premium. The receipt of donated shares by the entity
is recorded by means of a memorandum entry.

ILLUSTRATION

Mr. Zee, a shareholder donated to Co. D 1,000 ordinary shares with par value
P100. It is subsequently sold for P110 per share.

The pertinent entries are:

  (MEMO): “Received from Mr. Zee as donation 1,000 shares of ordinary
shares with par value P100.”

 The entry to record sale of donated shares is as follows:

Cash 110,000
Donated Capital 110,000

If, however, the donated shares are retired or cancelled prior to reissuance,
the entry is:

Ordinary share capital 100,000

Donated Capital 100,000

Donation of Capital

Contributions, including shares of an entity, received from shareholders shall

be recorded at the fair value of the item received and credited to donated
capital. Capital gifts or grants shall be recorded at their fair value when they
are received or are receivables. When they are received, they are generally
subsidies and credited to income. When they are not subsidies, a liability
account shall be credited until the restrictions are met. When these
restrictions are met, they are transferred to income. This is especially for
entities that receive gifts or grants of funds from nonshareholdersthat are
restricted for property and equipment additions.