Chapter 2 – Reconstitution of a Partnership Firm – Admission of a Partner
Table of Contents
Accountancy Chapter 2 – Reconstitution of a Partnership Firm – Admission of a Partner
1. Reconstitution of a Partnership Firm
Reconstitution occurs when there’s a change in the agreement between partners. It involves:
- Admission of a new partner.
- Change in the profit-sharing ratio.
- Retirement or death of an existing partner.
The key implication of reconstitution is the ending of the old partnership agreement and the formation of a new one while keeping the firm intact.
2. Modes of Reconstitution of a Partnership Firm
A partnership firm may be reconstituted in any of the following ways:
2.1. Admission of a New Partner
A new partner can be admitted to the firm to bring in additional capital or managerial expertise. Admission typically requires the unanimous consent of the existing partners.
- Example: If partners Hari and Haque (3:2 ratio) admit John for a 1/6 share, the partnership is reconstituted.
2.2. Change in Profit Sharing Ratio Among Existing Partners
Partners may decide to alter their existing profit-sharing ratio due to changes in their roles or capital contributions.
- Example: Partners Ram, Mohan, and Sohan (3:2:1 ratio) may change to an equal sharing ratio if Sohan contributes more capital.
2.3. Retirement of an Existing Partner
A partner may retire due to old age, illness, or change in interests. In such cases, the partnership is reconstituted with the remaining partners continuing the business.
- Example: Roy, Ravi, and Rao (2:2:1 ratio) are partners, and Ravi retires due to illness.
2.4. Death of a Partner
If a partner dies, the partnership is reconstituted, assuming the remaining partners continue the business. The deceased partner’s share must be settled.
- Example: X, Y, and Z (3:2:1 ratio) continue after X’s death, with Y and Z sharing future profits equally.
3. Admission of a New Partner
When a new partner is admitted, the firm’s resources may need augmentation. Upon admission, the new partner gains the right to share in the firm’s assets and profits.
- Contribution: The new partner contributes capital, which may include premium or goodwill to compensate existing partners for the reduction in their profit share.
4. New Profit Sharing Ratio
When a new partner is admitted, the old partners sacrifice part of their profit in favor of the new partner. This requires calculating the new profit-sharing ratio and sacrificing ratio. This calculation may depend on various methods and situations.
Example Calculations:
- If Anil and Vishal (3:2 ratio) admit Sumit for 1/5 share, the new ratio becomes 12:8:5 (based on their old ratio).
5. Sacrificing Ratio
The sacrificing ratio is the proportion in which the existing partners forgo their share of profits in favor of the new partner.
- Formula: Sacrificing Ratio = Old Share – New Share
- This ratio helps allocate goodwill brought in by the new partner to compensate the sacrificing partners.
6. Goodwill
Goodwill represents the firm’s reputation and its ability to earn super profits. During reconstitution, goodwill must be adjusted to reflect the changes in ownership or profit-sharing.
6.1. Factors Affecting Goodwill
- Nature of business: High-demand products contribute to high goodwill.
- Location: Centrally located businesses generally have higher goodwill.
- Efficiency of management: A well-managed firm tends to enjoy higher goodwill.
- Market conditions: Monopoly or limited competition often increases goodwill.
6.2. Methods of Valuing Goodwill
- Average Profits Method: Multiply average profits by the number of years’ purchase.
- Example: If the average profit is Rs. 20,000 and goodwill is valued at 3 years’ purchase, goodwill = Rs. 60,000.
- Super Profits Method: Goodwill = Super Profits × Number of years’ purchase.
- Example: Super profits are Rs. 3,000, and the firm expects to earn super profits for 5 years. Goodwill = Rs. 15,000.
- Capitalization Method: Goodwill is the difference between the capitalized value of average profits and the actual capital of the firm.
7. Revaluation of Assets and Liabilities
When a firm is reconstituted, assets and liabilities must be revalued. This ensures that their values are up-to-date, reflecting current market conditions. Any gains or losses are transferred to the old partners’ capital accounts in the old profit-sharing ratio.
- Examples of Revaluation:
- Increase in the value of assets (credited to Revaluation A/c).
- Decrease in the value of assets (debited to Revaluation A/c).
- Unrecorded assets/liabilities must also be accounted for.
8. Adjustment for Accumulated Profits and Losses
Accumulated profits, such as General Reserves or Profit and Loss Account, belong to the old partners. These reserves must be distributed among the old partners before the new partner is admitted.
- Journal Entry for Adjustment:
- General Reserve A/c Dr.
- To Old Partners’ Capital A/c
9. Adjustment of Partners’ Capitals
After reconstitution, the capital of each partner is adjusted based on the new profit-sharing ratio. This ensures that the new partner’s capital is proportional to their share in the firm’s profits and assets.
10. Hidden Goodwill
If goodwill is not specified during admission, it can be inferred from the capital introduced by the new partner relative to their profit share. The difference between the firm’s total capital and the implied value is attributed to goodwill.
- Example: If C is admitted with Rs. 60,000 for a 1/3 share, the total capital of the firm becomes Rs. 1,80,000, and the existing capital is Rs. 1,50,000. The hidden goodwill is Rs. 30,000.
11. Accounting for Goodwill
There are several cases for accounting for goodwill:
11.1. When the New Partner Brings Goodwill in Cash:
- The amount brought as goodwill is credited to the sacrificing partners’ capital accounts in the sacrificing ratio.
11.2. When Goodwill is Not Brought in Cash:
- If goodwill is not brought in by the new partner, their current account is debited for the goodwill, and the sacrificing partners’ capital accounts are credited.