How a Sole Proprietorship is formed?

A sole proprietorship is formed when an individual starts a business. It is easy to form because the bureau of internal revenue or BIR is not strict to the sole proprietorship. Moreover, it is not necessary to submit an audited financial statement. When filing taxes, the owner will just simply add the business income to his / her personal income. This is because the sole proprietorship entity and the owner are the same.

Advantage of Sole Proprietorship 

One of the advantages is to avoid double taxation. Double taxation means the income tax being paid is twice on the same source of income. For instance, in a partnership form of business, the partnership business income is taxed. When the net income after tax is distributed to the partners, the partner’s personal income is taxed.

The income derived from the partnership is taxed and the partner’s personal income is taxed. And also, the same source of income is taxed twice that’s why it’s called double taxation. On the other hand, business income is reported together with the personal income as one in a sole proprietorship. While in a sole proprietorship, the business income is reported together with the personal income as one. Of course, this is advantageous on the part of the business owner.

Moreover, the bureau of internal revenue BIR does not require sole proprietorship to submit audited financial statements. It’s an advantage because the owner doesn’t need to hire an external auditor to submit an audited financial statement. This saves the cost of operation.

In addition to the advantage is that sole proprietorship is easy to put up because it doesn’t require much capital. The owner can start small and scale it later on. Moreover, the requirements are minimal, especially for start-ups.

Another advantage is that sole proprietorship can outsource bookkeeping services worldwide. Because of the minimal cost of outsourcing bookkeeping. There are millions of sole proprietors in the US. Furthermore, most of them use QuickBooks online for bookkeeping. Bookkeeping services like payroll, bank reconciliation, taxes, etc.

See more on Bookkeeping Services

The Disadvantage of Sole Proprietorship 

The disadvantage of a sole proprietorship is the unlimited liability. The sole proprietorship entity is the same as the owner of the business. This means that the liability of the business is also the liability of the owner. This also means that the debtor’s claim is up to the extent of the owner’s assets. The proprietor should be meticulous about the financial status of the business. Every business results good or bad happens gradually, it does not happen overnight. Moreover, If the proprietor neglects the signs of continuously poor output, it could lead to the worst scenario.

A scenario like the business liability expands that the owner’s asset is no longer enough to cover up debts. That’s why there are sole proprietors that ended up being broke and homeless because they fail to know their numbers. And also, they fail to monitor the liquidity of the business. Otherwise, they fail to address wrong decision-making. On the other hand, if the proprietor is mindful and good in business, it will take off and grow.

How a Sole Proprietorship Dissolves? 

1.) The owner stops running the business.

2.) The proprietor passed away

3.) Bankruptcy – proprietorship is unable to fulfill its financial obligations.

4.) When a proprietor decides to invite a partner/s.

5.) When two sole proprietors decide to join together and form a partnership.

Sole Proprietorship converted into a Partnership

The sole proprietorship converted into a partnership is possible for a growing business. To convert a sole proprietorship into a partnership, there are steps to follow. These steps are done to convert the sole proprietorship into a partnership.

Here are the steps or guide:

1.) All nominal accounts should be closed to capital account. It also includes the drawing account of the proprietor.

2.) Assets should be valued at fair market value. Otherwise, the values agreed upon by the “to be” partners. Usually, partners set valuations to the proprietor’s assets.

3.) Closing of accumulated depreciation accounts. The reason for closing the accumulated depreciation because it pertains to the proprietorship. Moreover, it is unreasonable for a new entity to start with an existing accumulation of expenses (depreciation). Accumulated depreciation is the depreciation expenses for previous years related to fixed assets.

4.) Record the investment of the incoming partner/s.

Note: All asset adjustments shall be made to the owner’s capital account. Except if the asset has a contra account. If so, then the adjustment should be made through the contra account.

Examples of contra account:

1.) Allowance for doubtful accounts – it is a contra asset account. Allowance is set for possible uncollectible accounts. Normally a deduction to accounts receivable.

2.) Accumulated depreciation – the total of all depreciation expenses recorded in the previous period. You are aware that fixed asset value decreases over time. Because fixed assets have a useful life. But this doesn’t mean you deduct a certain amount directly to the fixed asset accounts. The proper way to decrease a fixed asset value is through contra accounts. Accumulated depreciation is an example of contra account of a fixed asset. It is a deduction from the related fixed assets.

3.) Unamortized discounts/premium – this contra account is for bond investment for asset account and bonds payable for liability account. It is also the difference between the par value and the proceeds from the sale of bonds. The par value is the written amount on the certificate of bonds.

Illustration:

Tai is a single proprietor. His business is growing so fast for the past two years. Tai wants to expand the business. So, he invited Patrick for capitalization purposes. Patrick invested P3,800,000 cash. Tai and Patrick agreed to register the partnership as TP partnership trading. In addition, the business operation will start on May 21, 2021.  

The statement of the financial position of Tai trading before the admission of Patrick

When two or more partners decided to form a partnership, they shall have an agreement. The agreement could be verbal or written. It is better to be a written agreement. Because there are some partner/s who sometimes deny the words they have said in the future. A written agreement is a protection for each partner in case of jeopardy. These are the agreement of Tai and Patrick in partnership formation.

1.) Allowance for doubtful accounts should be 15% of the accounts receivable.

2.) Merchandise inventory should be at a fair market value of P1,200,000.

3.) An additional amount of P10,000 to the office supplies.

4.) Land value at a fair market value of P1,000,000

5.) The remaining useful life of furniture and fixtures is 2 years as agreed. Therefore, it should be 60% depreciated.

6.) No other adjustments to the remaining assets.

The existing financial statement of Tai before forming the partnership shall be rectified as agreed. This is to bring the value of Tai trading assets at fair market valuation.

Presented below are the adjustments. These are the following single entries to adjust the balances of assets.

1.) The existing allowance for the doubtful account is 10%, so you need to add 5% more to arrive at the agreed 20%. Here’s the entry to do that.

Debit:   Tai, Capital     P50,000

Credit:  Allowance for Doubtful Account        P50,000

Description: To add more allowance to accounts receivable account

2.) There is an understatement of Merchandise inventory. To bring the balance to fair market value you should add P200,000. Journal entry:

Debit: Merchandise Inventory    P200,000

Credit: Tai, Capita       P200,000

Description: To adjust the value of merchandize inventory to fair market value

3.) Simply add P10,000 to the value of office supplies as agreed in number three. Here is the journal entry:

Debit: Office Supplies    P10,000

 Credit: Tai, Capital          P10,000

 Description: To adjust the value of office supplies to fair market value

4.) An understatement of the land value of Tai trading. You need to adjust the Land balance based on fair market value. Here is the journal entry:

Debit; Land      P200,000

Credit: Tai, Capital          P200,000

Description:  To adjust the value of land to fair market value

5.) The existing accumulated depreciation of Tai trading is 40%. Accumulated depreciation shall be 60% of furniture and fixtures as agreed. To do that you need to make a journal entry like this:

 Debit: Tai, Capital          P100,000

 Credit:                        Accumulated Depreciation – Furniture and Fixtures  P100,000

 Description: To add depreciation expense due to furniture and fixtures remaining useful life is 2 years or 40%

All the adjustments are posted and reflected in Tai trading books. We are done with the first and second steps in converting sole proprietorship into partnership. Now let’s move on to the third step which is closing the accumulated depreciation.

Step three: Closing of accumulated depreciation account.

Journal entry to close accumulated depreciation:

Debit: Accumulated Depreciation – Furniture and Fixtures    P300,000

Credit: Tai, Capital     P300,000

Description: To close accumulated depreciation – furniture and fixtures account

Note: Normally, to close an accumulated depreciation account it should be close to the fixed asset related to it. But since we are converting the sole proprietorship into a partnership, all adjustments shall be made to the capital account.

The closing of accumulated depreciation – furniture and fixtures shall be posted and reflected in Tai trading book. After that, we are now in the last step which is to record the investment of the incoming partner.

Step four: Record the investment of Patrick

The entry to record the admission is below.

Debit:                                         Cash      P1,000,000

Credit:                                     Patrick, Capital   P1,000,000

Description: To record the investment of Patrick in the partnership

The investment of Patrick shall be posted and reflected in Tai Trading books to form the partnership. After posting all the necessary journal entries, the statement of financial position will be presented like this:

Remember that recording the admission of Patrick as the last steps formed the partnership. Since the partnership is formed, we will now change the name of the business. From Tai Trading, it will become TP Partnership Trading. Sole Proprietorship is dissolved the moment you adjusted the assets based on agreement and recorded the admission of Patrick. Hence, as the sole proprietorship is dissolved the Partnership is formed. The adjustments presented above are all on a single entry. Here is another way to record all adjustment as one – compound entry:

Debit: Merchandise Inventory P200,000

Debit: Office Supplies P10,000

Debit: Land P200,000

 

Credit: Allowance for Doubtful Account P50,000

Credit: Accumulated Depreciation – Furniture and Fixtures     P100,000

Credit:  Tai, Capital P260,000

Description: To record all the adjustments as agreed upon by partners “to be”

Note: The amount presented on Tai’s capital account is the net effect of debits and credits adjustments resulting in the ending of credit balance. Hence, the total capital adjustment of Tai is P260,000

See more examples of Journal entry.

Two Sole Proprietorship joined to form a Partnership

When two sole proprietorships joined together to form a partnership, they can decide what book to use. The partnership could use either of the old books or will use a new set of accounting books. Whatever book the partnership will decide to use, both existing books shall be adjusted to their fair market value.

The steps in converting sole proprietorship into partnership are the same when two sole proprietorships joined to form a partnership. 

First, closing of nominal accounts including the proprietor drawings account. Then assets shall be at fair market value. After that, you need to close the accumulated depreciation account. Finally, record the investments of incoming partners if the old book will be used. But if the partners decide to use a new book then record both partner’s investments in the new book.

Illustration:

Elon, owner of the trading business wants to expand his business. He wants to go digital trading. On the other hand, Elon’s friend Alex, owner of the trading business wants to go digital trading too. The two decided to combine their businesses to form a digital trading partnership. The partnership shall be called E-lex Partnership. The partners agreed to contribute 50/50. Moreover, the operation will start on May 21, 2021. The partners decide to use Elon’s existing book

Here are the following adjustments:

1.) Allowance for the doubtful account for both shall be 10%of accounts receivable.

2.) The merchandise inventory of Elon should be at P1,500,000. No adjustment for Alex’s merchandise inventory.

3.) Office supplies of both partners shall be at P60,000.

4.) Elon’s Land valued at P1,000,000 while Alex land shall be at P1,500,000.

5.) Both buildings are depreciated right.

6.) Accumulated depreciation for furniture and fixture valued at 50% of furniture and fixture.

7.) Both should contribute the same amount of investment.

To form a partnership of two sole proprietors both books shall be adjusted. Even if partners agree to use Elon’s existing book, both books shall be adjusted to fair market value. Here are the Financial Statements of both partners before Partnership formation:

Here are the journal entries for adjustment:

1.) The existing allowance for the doubtful account for both partners is at 10%. With the given data you don’t need to make a journal entry to both books. Indeed, Allowances set to accounts receivable are correct.

                  -No Entry—

2.) There’s an understatement of Elon’s merchandise inventory by P500,000. Furthermore, to bring the balance to fair market value you should add P500,000 to Elon’s book. Journal entry:

Debit:                            Merchandise InventoryP500,000

Credit: Elon, Capital          P500,000

Description: To adjust the value of merchandize inventory to fair market value

Note: In the agreement, there will be no adjustment on Alex’s book – Merchandise Inventory account. Indeed, the Merchandise Inventory of Alex is at fair market value.

3.) Office supplies valued at P60,000 for both partners. In this adjustment, you should make a journal entry for both partner’s books. Here are the entries:

Journal Entry 3a: 

Debit: Office Supplies    P10,000

Credit: Elon, Capital        P10,000

Description: To adjust the value of office supplies to fair market value

Journal Entry 3b: 

Debit: Office Supplies     P10,000

Credit: Alex, Capital         P10,000

Description: To adjust the value of office supplies to fair market value

4.) Elon Land valued at P1,000,000 while Alex land valued at P1,500,000. The existing land value of Elon is P800,000 so you need to add P200,000 more to update the balance. The existing land value of Alex is P1,000,000 so you need to add P500,000 more to update the balance. Here’s the entry to bring the balance at fair market value:

 Journal Entry 4a: 

Debit; Land     P200,000

Credit: Elon, Capital   P200,000

Description: To adjust the value of land to fair market value

Journal Entry 4b: 

Debit: Land     P500,000

Credit: Alex, Capital   P500,000

Description: To adjust the value of land to fair market value

5.)The accumulated depreciation for both buildings is correct. Therefore, there will be no entry for accumulated depreciation. 

                —No Entry—

6.) The existing accumulated depreciation of both partners is at 40%. Accumulated depreciation shall be 50% of furniture and fixtures as agreed. Therefore, you need to add 10%. To do that you need to make a journal entry like this of both books:

Journal Entry 5a:

Debit: Elon, Capital     P50,000

Credit: Accumulated Depreciation – Furniture and Fixtures      P50,000

Description: To add depreciation expense to furniture and fixtures 

Journal Entry 5B:

Debit: Alex, Capital        P50,000

Credit:  Accumulated Depreciation – Furniture and Fixtures         P50,000

Description: To add depreciation expense to furniture and fixtures 

7.) Remember that both partners agreed to contribute 50/50 investments. All the adjustments are posted. Hence, Alex’s assets are valued at P3,060,000 while Elon’s assets are at P3,510,000. In this case, Alex should contribute additional cash of P450,000 to be equal to Elon’s total asset. You should make another Journal entry to record additional cash investment of Alex amounting to P450,000. Journal Entry:

Debit: Cash       P450,000

Credit: Alex, Capital      P450,000

Description: To add depreciation expense to furniture and fixtures 

The entry made on Elon and Alex’s books is all single entries. You also have an option to record the entries compounded.

Here’s the compound entry:

Elon’s Book:

Debit: Merchandise Inventory P500,000

Debit: Office Supplies P10,000

Debit: Land    P200,000

Credit: Accumulated Depreciation – Furniture and Fixtures P50,000

Credit: Elon, Capital P660,000

Description: To record all the adjustments as agreed upon by both partners

Alex’s Book:

Debit: Cash P450,000

Debit: Office Supplies P10,000

Debit: Land P500,000

Credit: Accumulated Depreciation – Furniture and Fixtures P50,000

Credit: Alex, Capital P910,000

Description: To record all the adjustments as agreed upon by both partners

All adjustments shall be posted and reflected in the two books. Presented below are the adjusted book balances of both partners.

Two sole proprietorships usually join together for expansion called Partnership.

If you need help, feel free to ask questions or contact us.