Key Points

Reconstitution of a partnership firm refers to any change in the existing partnership agreement. This ends the old agreement and starts a new one with a changed relationship among partners, though the firm continues its business.

A partnership is reconstituted upon the admission of a new partner, a change in the profit-sharing ratio, retirement of a partner, or the death or insolvency of a partner.

When a new partner is admitted, key accounting adjustments are needed for the new profit-sharing ratio, sacrificing ratio, goodwill, revaluation of assets and reassessment of liabilities, and distribution of accumulated profits or losses.

The new profit sharing ratio is the ratio in which all partners will share future profits. The sacrificing ratio is the proportion in which old partners sacrifice their profit share for the new partner, calculated as Old Share minus New Share.

The sacrificing ratio is crucial for distributing the premium for goodwill brought by the new partner. This amount compensates the old partners for the loss of their share in the firm's super profits.

Goodwill is an intangible asset representing the value of a firm's reputation and business connections, which enables it to earn profits above the normal rate of return. It exists only when a firm earns super profits.

The three main methods for valuing goodwill are the Average Profits Method, Super Profits Method, and Capitalisation Method. The method used is typically decided by the partners.

Super Profit is the excess of a firm's actual average profit over its normal profit. Under this method, goodwill is calculated by multiplying the super profit by an agreed number of years' purchase.

Goodwill can be calculated either by capitalising the average profits and subtracting the net assets, or by directly capitalising the super profits. Both approaches yield the same result.

When a new partner brings their share of goodwill (premium) in cash, the amount is credited to the sacrificing partners' capital accounts in their sacrificing ratio.

If a new partner is unable to bring their share of goodwill in cash, their current account is debited for the amount, and the sacrificing partners' capital accounts are credited.

If goodwill already appears in the books at the time of admission, it must be written off by debiting the old partners' capital accounts in their old profit-sharing ratio.

Hidden goodwill is not explicitly stated but is inferred from the new partner's capital contribution and profit share. It is the excess of the firm's total capital (implied by the new partner's capital) over the actual combined capital.

A Revaluation Account is prepared to record the increase or decrease in the value of assets and liabilities at the time of reconstitution. The resulting profit or loss is shared by the old partners in their old profit-sharing ratio.

Existing reserves, accumulated profits, or losses shown in the balance sheet are distributed among the old partners in their old profit-sharing ratio before the new partner's admission.

Partners may agree to adjust their capitals to be proportionate to the new profit-sharing ratio. Any surplus or deficit for a partner is adjusted by withdrawal, additional contribution of cash, or through their current account.

When existing partners change their profit-sharing ratio, it also amounts to reconstitution. This requires adjustments for goodwill, revaluation, and accumulated profits, similar to the admission of a partner.