Chapter 3 – Reconstitution of a Partnership Firm – Retirement/Death of a Partner
Table of Contents
Accountancy Chapter 3 – Reconstitution of a Partnership Firm – Retirement/Death of a Partner
1. Introduction to Reconstitution on Retirement/Death of a Partner
- Reconstitution of a Partnership Firm happens when a partner retires or passes away, causing a change in the firm’s composition but allowing the business to continue.
- A new partnership agreement is drafted, and certain financial adjustments are made for the retiring or deceased partner.
- Accounting Treatment on retirement and death of a partner involves settling the outgoing partner’s share, recalculating the profit-sharing ratio, and adjusting for goodwill, revaluation of assets, liabilities, and accumulated reserves or losses.
2. Calculation of Amount Due to the Retiring/Deceased Partner
The sum payable to the retiring or deceased partner includes:
- Credit Balance of Capital Account: The balance in their capital account after adjustments.
- Credit Balance of Current Account (if any): Their portion of funds.
- Share of Goodwill: Their share of the firm’s goodwill.
- Accumulated Profits or Reserves: Such as general reserves or retained earnings.
- Share of Revaluation Profits: Gain from revaluation of assets and liabilities.
- Profits up to Retirement/Death: Partner’s share of the firm’s profits until the date of retirement or death.
- Interest on Capital: Calculated up to the retirement/death date if applicable.
- Salary/Commission: Due to them, if specified in the agreement.
Deductions could include:
- Debit Balance of Current Account.
- Goodwill to be Written Off: If goodwill is debited, their share may be deducted.
- Accumulated Losses.
- Revaluation Loss: Their share of any loss on revaluation of assets and liabilities.
- Loss up to Retirement/Death: Their share of any loss incurred up to the date of retirement or death.
- Drawings and Interest on Drawings.
3. New Profit-Sharing Ratio
After retirement or death, the remaining partners adjust their profit-sharing ratio:
- If the share of the outgoing partner is taken by the remaining partners in their old profit-sharing ratio, the new ratio remains the same.
- If the partners take the outgoing partner’s share in a different ratio, the new profit-sharing ratio is calculated accordingly.
- Formula: New Share = Old Share + Acquired Share.
Example: If partners A, B, and C share profits in the ratio of 5:3:2 and B retires, A and C may take B’s share either equally or in another ratio, determining their new ratio.
4. Gaining Ratio
- Gaining Ratio is the proportion in which the remaining partners acquire the retiring/deceased partner’s share.
- If the remaining partners acquire the share in the old profit-sharing ratio, the gaining ratio is the same as the old one.
- Formula: Gaining Ratio = New Share – Old Share.
Example: If Amit, Dinesh, and Gagan have a profit ratio of 5:3:2 and Dinesh retires, leaving Amit and Gagan with a new ratio of 3:2, the gaining ratio will be calculated to understand how much share they gained from Dinesh.
5. Treatment of Goodwill
The outgoing partner is entitled to their share of goodwill, as goodwill is earned collectively by all partners. Goodwill adjustments vary based on whether it already appears in the books or not:
- When Goodwill Does Not Appear in Books: Goodwill is credited to the outgoing partner’s account, and debited to the capital accounts of the remaining partners in their gaining ratio.
- Hidden Goodwill: If a lump sum is paid to the outgoing partner exceeding their account balance, the excess amount is treated as their share of goodwill.
Example: If a retiring partner’s capital account stands at Rs. 60,000 and they are paid Rs. 75,000, the excess Rs. 15,000 is treated as goodwill.
6. Revaluation of Assets and Liabilities
Revaluation ensures that assets and liabilities reflect their current market value. Any gain or loss is transferred to the partners’ capital accounts in their old profit-sharing ratio. Entries include:
- Increase in Asset Value: Asset account is debited, revaluation account credited.
- Decrease in Asset Value: Revaluation account is debited, asset account credited.
- Increase in Liability: Revaluation account debited, liability account credited.
- Unrecorded Assets/Liabilities: Adjustments are made accordingly.
7. Adjustment for Accumulated Profits and Losses
Accumulated profits (e.g., general reserve) and losses are distributed among all partners, including the retiring/deceased partner, in their old profit-sharing ratio.
Example Entry:
- For Profits: General Reserve A/c Dr. To Partners’ Capital A/c (in old ratio).
- For Losses: Partners’ Capital A/c Dr. To Profit & Loss A/c (in old ratio).
8. Settlement of Retiring Partner’s Amount
The firm must settle the retiring partner’s dues, which may be paid:
- Lump Sum Payment: Entire amount is paid immediately.
- Transfer to Loan Account: If the firm cannot pay immediately, the amount is transferred to the partner’s loan account, accruing interest (typically 6%).
- Installments: Payment is made in installments, including interest.
Example: If a retiring partner is owed Rs. 60,000 and the firm agrees to pay in four installments with 12% interest, the necessary journal entries will record the installment payments and interest.
9. Adjustment of Capital
When a partner retires, the remaining partners may decide to adjust their capital in proportion to the new profit-sharing ratio. If there is an excess or deficiency in capital, the partners can:
- Withdraw the excess amount.
- Bring in additional capital.
Example: If after adjustments, partner A has excess capital, they can withdraw it, while partner B might need to bring in additional capital to match the new ratio.
10. Death of a Partner
The procedure for the death of a partner mirrors that of retirement. The deceased partner’s legal representatives are entitled to the partner’s share, which includes goodwill, accumulated profits, revaluation gains, and share of profits up to the date of death.
11. Profit for the Intervening Period
If a partner retires or dies mid-year, their profit share for the period from the last balance sheet to the retirement/death date is calculated based on:
- Previous Year’s Profit.
- Average Profits of the Last Three Years.
- Sales Basis (if specified).