Modes of Reconstitution of a Partnership Firm Reconstitution of a partnership firm usually takes place in any of the following ways:

Admission of a new partner:

 A new partner may be admitted when the firm needs additional capital or managerial help.

Change in the profit sharing ratio among the existing partners:

Sometimes the partners of a firm may decide to change their existing profit sharing ratio. This may happen an account of a change in the existing partners’ role in the firm.

Retirement of an existing partner:

 It means withdrawal by a partner from the business of the firm which may be due to his bad health, old age or change in business interests. In fact a partner can retire any time if the partnership is at will.

Death of a partner:

 Partnership may also stand reconstituted on death of a partner, if the remaining partners decide to continue the business of the firm as usual.

According to the Partnership Act 1932, a new partner can be admitted into the firm only with the consent of all the existing partners unless otherwise agreed upon. With the admission of a new partner, the partnership firm is reconstituted and a new agreement is entered into to carry on the business of the firm. A newly admitted partner acquires two main rights in the firm–

 1. Right to share the assets of the partnership firm; and

 2. Right to share the profits of the partnership firm.

In the case of an established firm which may be earning more profits than the normal rate of return on its capital the new partner is required to contribute some additional amount known as premium or goodwill.

New Profit Sharing Ratio

 When new partner is admitted he acquires his share in profits from the old partners. In other words, on the admission of a new partner, the old partners sacrifice a share of their profit in favour of the new partner.

In any cason admission of a new partner, the profit sharing ratio among the old partners will change keeping in view their respective contribution to the profit sharing ratio of the incoming partner. Hence, there is a need to ascertain the new profit sharing ratio among all the partners. This depends upon how does the new partner acquires his share from the old partners for which there are many possibilities.

Illustration 1

 Arushi and Vaishnavi are partners sharing profits in the ratio of 3:2. They admitted Sunita as a new partner for 1/5 share in the future profits of the firm. Calculate new profit sharing ratio of Arushi, Vaishnavi and Sunita.

 Solution

Sunita’s share = 1/ 5

Remaining share = 1 -1/ 5  = 4/ 5

Arushi’s new share = 3/ 5 of 4/ 5 = 12/ 25

Vaishnavi’s new share = 2/ 5 of 4/ 5 = 8 /25

New profit sharing ratio of Arushi, Vaishnavi and Sunita will be 12:8:5.

Note: It has been assumed that the new partner acquired his share from old partners in old ratio.

Sacrificing Ratio

 The ratio in which the old partners agree to sacrifice their share of profit in favour of the incoming partner is called sacrificing ratio. The sacrifice by a partner is equal to :

Old Share of Profit – New Share of Profit

Premium Method

This method is followed when the new partner pays his share of goodwill in cash.  The amount of premium brought in by the new partner is shared by the existing partners in their ratio of sacrifice.  If this amount is paid to the old partners directly (privately) by the new partner, no entry is made in the books of the firm.  But, when the amount is paid through the firm,  which is generally the case, the following journal entries are passed:

-1. Cash A/c Dr.

To Goodwill A/c (Amount brought by new partner as premium)

-2.  Goodwill A/c Dr.

To Existing Partners Capital A/c (Individually)

(Goodwill distributed among the existing partners in their sacrificing ratio)

 

When goodwill already exists in books:

 The above treatment of goodwill was based on the assumption that there was no goodwill account in the books of the firm. However, It is quite possible that when a new partner brings in his share of goodwill in cash, some amount of goodwill already exists in books. In that case, after crediting the old partners by the amount of goodwill brought in by the new partner, the existing goodwill must be written off by debiting the old partners in their old profit sharing ratio.

Revaluation Method

This method is followed when the new partner does not bring in his share of goodwill in cash.  In such a situation, the goodwill account is raised in the books of account by crediting the old partners in the old profit sharing ratio. When goodwill account is to be raised in the books of account there are two possibilities,

(a) No goodwill appears in books at the time of admission, and

 (b) Goodwill already exists in books at the time of admission

(a) When no goodwill exists in the books:

When no goodwill exists in the books at the time of the admission of a new partner, the goodwill account must be raised at its full value.  This can be done by debiting goodwill account with its full value and crediting the old partners’ capital accounts in their profit sharing ratio.  The journal entry will be: Goodwill A/c Dr

. To Old Partners’ Capitals A/c (individually)

(Goodwill raised at full value in the old ratio)

The goodwill thus raised shall appear in the balance sheet of the firm at its full value.

(a) When goodwill already exists in the books :

If the books already show some balance in the Goodwill Account, the adjustment for goodwill in the old partner’s capital accounts shall be made only for the difference between the agreed value of goodwill and the amount of goodwill appearing in books.

The journal entries will be as under:

(a)When the value of goodwill appearing in the books is less than the agreed value.

 Goodwill A/c Dr.

 To Old Partners’ Capital A/c (individually)

 (Goodwill raised to its agreed value)

When the value of goodwill appearing in the books is more than the agreed value.

Old Partners’ Capital A/c (individually) Dr.

 To Goodwill A/c

(Goodwill brought down to its agreed value)

Accounting standard 10 (AS–10) on “Accounting for Fixed Assets” in its Para 16 states that Goodwill, in general, is recorded in the books only when some consideration in money or money’s worth has been paid for it. Whenever a business is acquired for a price (payable either in cash or in shares or otherwise) which is excess of the net assets taken over, the excess is termed as goodwill’. Goodwill arises from business connections, trade name or reputation of an enterprise or from other intangible benefits enjoyed by an enterprise.

This is stretching the interpretation of AS–10 too far. What this accounting standard implies is that normally goodwill should not be brought into books unless it is paid for, and whenever it is recorded it should be written- off over a period.

Adjustment for Accumulated Profits and Losses

 

Sometimes a firm may have accumulated profits not yet transferred to capital accounts of the partners. These are usually in the firm of general reserve, reservefund and/or Profit and Loss Account balance. The new  partner is not entitled to have any share in such accumulated profits.  These are distributed among the partners by transferring it to their capital accounts in old profit sharing ratio. Similarly, if there are some accumulated losses in the form of a debit balance of profit and loss account appearing in the balance sheet of the firm.

Journal Entries –

Profit & loss account A/c dr

To old partners                                     (  in old ratio)

General Reserve A/c dr

To old partners                                  (in old ratio)

 

Revaluation of Assets and Reassessment of Liabilities

It is always desirable to ascertain whether the assets of the firm are shown in books at their current values. In case the assets are overstated or understated, these are revalued. Similarly, a reassessment of the liabilities is also done so that these are brought in the books at their correct values.  At times there may also be some unrecorded assets and liabilities of the firm. These also have to be brought into the books of the firm. For this purpose the firm has to prepare the Revaluation Account. The gain or loss on revaluation of each asset and liability is transferred to this account and finally its balance is transferred to the capital accounts of the old partners in their old profit sharing ratio.

 

                                            Revaluation A/C

   DR                                                                                                                                                                Cr

Particular	Amount	Particular	Amount
To decrease in assets Toincrease in liabilities To unrecorded liability To Profit on revaluation		By increase in assets By decrease in liabilities By unrecorded assets By Loss on revaluation

The journal entries recorded for revaluation of assets and reassessment of liabilities are as follows:

 (i) For increase in the value of an asset

 Asset A/c Dr.

To Revaluation A/c (Gain)

(ii) For reduction in the value of an asset

 Revaluation A/c Dr.

 To Asset A/c (Loss)

 (iii) For appreciation in the amount of a liability

Revaluation A/c Dr.

 To Liability A/c (Loss)

 (iv) For reduction in the amount of a liability

 Liability A/c Dr.

To Revaluation A/c (Gain)

(v) For an unrecorded asset

 Asset A/c Dr.

To Revaluation A/c (Gain)

 (vi) For an unrecorded liability

Revaluation A/c Dr.

To Liability A/c (Loss)

(vii) For transfer of gain on Revaluation if credit balance

 Revaluation A/c Dr.

 To Old Partners Capital A/cs (Old ratio) (individually)

(viii) For transferring loss on revaluation

Old partner’s Capital A/cs Dr. (Individually) (Old ratio)

 To Revaluation A/c

Financial Statements prepared by a partnership-

• Revaluation account
• Journal Entries for adjustment
• Partner’s Capital Account
• Bank Account
• Balance Sheet

DR                                                   Partner’s Capital Account                                                    CR

Date	Particular	Partner1	Partner2	Partner3	Date	Particular	Partner1	Partner2	Partner3
						By bal b/d
	To revaluation loss					By Revaluation profit
	To drawings					By General reserve
						By profit & loss account
	To bal c/d

 

 

Hidden Goodwill

If the goodwill of the  firm is not given and the partner brings an appropriate amount of goodwill.

Then, calculate the amount of goodwill through the capital brought by the partner in the business.

e.g.

If the partner brought Rs. 60,000 as his capital for 1/4^th share along with appropriate amount of goodwill. Capital of old partners be Rs. 30,000 each considering there are two partners at present A & B

In such as case, the goodwill of the firm would be

1. calculation of total capital

2. deducting all the capital old partners & new partner from step 1

Remaining amount is hidden goodwill

Capital of the partner –

Total capital of the firm = 60,000   =   60,000 x 4/1 =  Rs. 1,50,000

                                                       ¼  

Capital of the firm = 30,000+ 30,000+ 60,000 =Rs. 1,20,000

Goodwill = 1,50,000 – 1,20,000

                  = Rs. 30,000