Chapter Notes

Reconstitution of a Partnership Firm－ Admission of a Partner

When a partnership is formed, it's based on a specific agreement between the partners. Any change to this existing agreement is called the reconstitution of the partnership firm. This doesn't mean the business stops; the firm continues to operate, but under a new agreement. The relationships between the partners change, and sometimes the number of partners changes too.

Modes of Reconstitution of a Partnership Firm

A partnership firm can be reconstituted in several common ways:

• Admission of a new partner: This happens when the firm needs more money (capital) or someone with specific skills (managerial help). For a new partner to join, all existing partners must unanimously agree, unless their partnership deed says otherwise.
• Change in the profit sharing ratio among existing partners: Sometimes, partners decide to alter how they share profits. This could be because one partner is taking on more responsibility or contributing more capital. This change requires a new agreement, thus reconstituting the firm.
• Retirement of an existing partner: A partner might leave the business due to old age, poor health, or new business interests. When a partner withdraws, the firm is reconstituted with the remaining partners.
• Death of a partner: If a partner passes away, the partnership is reconstituted if the remaining partners decide to continue the business. They will create a new agreement among themselves.

Admission of a New Partner

Firms often admit a new partner to bring in additional capital for expansion or to gain valuable managerial expertise. According to the Partnership Act 1932, a new partner can only be admitted with the consent of all existing partners. This act of admission reconstitutes the firm, and a new partnership agreement is created.

A newly admitted partner gains two primary rights:

1. Right to share in the firm's assets.
2. Right to share in the firm's future profits.

In return for these rights, the new partner brings in an agreed-upon amount of capital. If the firm is well-established and profitable, the new partner may also be required to pay an additional amount called premium or goodwill. This payment compensates the existing partners for giving up a portion of their share in the firm's profits.

When a new partner is admitted, several key accounting adjustments are necessary:

• Calculating the new profit-sharing ratio.
• Calculating the sacrificing ratio.
• Valuing and adjusting for goodwill.
• Revaluing assets and reassessing liabilities.
• Distributing accumulated profits and reserves.
• Adjusting partners' capitals according to the new agreement.

New Profit Sharing Ratio

When a new partner joins, they get their share of future profits from the old partners. This means the old partners must "sacrifice" a part of their profit share. How this happens is decided mutually. If the agreement is silent, it's assumed that the old partners sacrifice their profits in their old profit-sharing ratio. The key is to calculate the new profit-sharing ratio for all partners, including the new one.

1. Sumit's share is 1/5.
2. The remaining share for Anil and Vishal is 1 - 1/5 = 4/5.
3. This remaining 4/5 share will be divided between Anil and Vishal in their old ratio (3:2).
   • Anil's new share = 3/5 of 4/5 = 12/25
   • Vishal's new share = 2/5 of 4/5 = 8/25
4. The new profit-sharing ratio of Anil, Vishal, and Sumit is 12:8:5.

Sacrificing Ratio

The sacrificing ratio is the ratio in which the old partners agree to give up their share of profit in favour of the new partner. This is a crucial calculation because the goodwill premium brought by the new partner is distributed among the old partners in this ratio. It's their compensation for the sacrifice they're making.

The formula to calculate a partner's sacrifice is: Old Share of Profit – New Share of Profit

• Rohit's Sacrifice:
  • Old Share: 5/8
  • New Share: 4/7
  • Sacrifice = 5/8 - 4/7 = (35 - 32) / 56 = 3/56
• Mohit's Sacrifice:
  • Old Share: 3/8
  • New Share: 2/7
  • Sacrifice = 3/8 - 2/7 = (21 - 16) / 56 = 5/56

The sacrificing ratio between Rohit and Mohit is 3:5.

Goodwill

Goodwill is one of the most important adjustments during the reconstitution of a firm. It represents the value of a firm's reputation and its ability to earn higher profits than a brand-new business.

Meaning of Goodwill

Over time, a successful business builds a good name, a strong reputation, and wide connections. This advantage helps it earn more profit compared to a newly set-up business. In accounting, the monetary value of this advantage is known as goodwill.

It is an intangible asset, meaning it has no physical existence. Goodwill exists only when a firm earns super profits—profits that are above the normal return expected in that industry. A firm earning only normal profits or incurring losses has no goodwill.

Factors Affecting the Value of Goodwill

Several factors can influence a firm's goodwill:

• Nature of business: Firms with high-demand products or stable demand tend to have more goodwill.
• Location: A business in a prime location with high customer traffic will have higher goodwill.
• Efficiency of management: Well-managed firms are more productive and cost-efficient, leading to higher profits and goodwill.
• Market situation: Firms operating in a monopoly or with limited competition can earn higher profits, increasing their goodwill.
• Special advantages: Having special licenses, patents, trademarks, or long-term contracts for supplies can significantly boost goodwill.

Need for Valuation of Goodwill

While goodwill is often valued when a business is sold, in a partnership, it's also needed in these situations:

• Change in the profit-sharing ratio among existing partners.
• Admission of a new partner.
• Retirement or death of a partner.
• Dissolution of a firm where the business is sold as a going concern.
• Amalgamation (merging) of partnership firms.

Methods of Valuation of Goodwill

Valuing an intangible asset like goodwill is complex. There are three main methods used in partnerships.

1. Average Profits Method

This method values goodwill based on the average profits of the last few years, multiplied by an agreed number of "years' purchase." The idea is that a new business would take a few years to start earning profits, so the buyer of an existing business pays for the profits they will likely earn in those initial years.

Goodwill = Average Profits × Number of years’ purchase

If profits show a clear increasing or decreasing trend, a weighted average might be used, giving more importance (weight) to recent years' profits.

2. Super Profits Method

This method is based on the idea that a buyer's real benefit is not the total profit, but the profit that is in excess of the normal return on capital in that industry. This excess profit is called super profit.

The steps are:

1. Calculate Average Profit: Based on past years' profits.
2. Calculate Normal Profit: This is the return you would normally expect on the capital invested. Normal Profit = Firm's Capital × (Normal Rate of Return / 100)
3. Calculate Super Profit: Super Profit = Average Profit – Normal Profit
4. Calculate Goodwill: Goodwill = Super Profit × Number of years’ purchase

3. Capitalisation Method

This method values goodwill by "capitalising" the firm's profits. It can be done in two ways:

• Capitalisation of Average Profits:

  1. Calculate the total value of the business based on its average profits and the normal rate of return: Capitalised Value = Average Profits × (100 / Normal Rate of Return)
  2. Determine the firm's actual capital (Net Assets = Total Assets - Outside Liabilities).
  3. Goodwill is the difference: Goodwill = Capitalised Value – Net Assets

• Capitalisation of Super Profits: This is a more direct method. It calculates the capital needed to earn the super profit. Goodwill = Super Profits × (100 / Normal Rate of Return)

Treatment of Goodwill

When a new partner joins, they must compensate the sacrificing partners for their share of the firm's goodwill. This payment is called the premium for goodwill.

When the New Partner Brings Goodwill in Cash

If the new partner pays the premium directly to the old partners privately, no entry is made in the firm's books. However, it is usually paid through the firm.

1. Entry for receiving cash for capital and goodwill: Bank A/c Dr. To New Partner's Capital A/c To Premium for Goodwill A/c

2. Entry for distributing the goodwill premium to old partners: Premium for Goodwill A/c Dr. To Sacrificing Partners' Capital A/cs (in their sacrificing ratio)

If the old partners decide to withdraw this amount, an additional entry is passed: Sacrificing Partners' Capital A/cs Dr. To Bank A/c

When the New Partner Does Not Bring Goodwill in Cash

If the new partner is unable to bring their share of goodwill in cash, the amount is debited to their Current Account, and the sacrificing partners' Capital Accounts are credited. This ensures the old partners are compensated without the new partner having to pay cash immediately.

Journal Entry: Incoming Partner's Current A/c Dr. To Sacrificing Partners' Capital A/cs (in their sacrificing ratio)

Hidden Goodwill

Sometimes, the value of goodwill is not explicitly stated. It must be inferred from the capital contributions and profit-sharing ratios.

1. Based on C's contribution, the total capital of the firm should be Rs. 60,000 × 3 = Rs. 1,80,000.
2. However, the actual total capital of A, B, and C is Rs. 45,000 + Rs. 45,000 + Rs. 60,000 = Rs. 1,50,000.
3. The difference, Rs. 1,80,000 – Rs. 1,50,000 = Rs. 30,000, is the implied or hidden goodwill of the firm.
4. C's share of this goodwill is 1/3 of Rs. 30,000 = Rs. 10,000. This amount would be adjusted through C's Current Account.

Adjustment for Accumulated Profits and Losses

Over the years, a firm may have accumulated profits in the form of a General Reserve, Reserve Fund, or a credit balance in the Profit and Loss Account. These belong to the old partners.

• Rule: Before a new partner is admitted, these accumulated profits must be distributed to the old partners in their old profit-sharing ratio.

Journal Entry for distributing profits: General Reserve A/c Dr. Profit and Loss A/c Dr. To Old Partners' Capital A/cs (in old ratio)

Similarly, if there are accumulated losses (like a debit balance in the Profit and Loss Account), they must also be written off against the old partners' capital accounts.

Journal Entry for distributing losses: Old Partners' Capital A/cs Dr. (in old ratio) To Profit and Loss A/c

Revaluation of Assets and Reassessment of Liabilities

At the time of admission, the firm's assets may be worth more or less than their book values. Similarly, liabilities might have changed. To be fair to all partners (old and new), it's essential to record assets and liabilities at their current values.

This is done using a temporary account called the Revaluation Account.

• Gains are credited: Any increase in the value of an asset or decrease in the value of a liability is a gain and is credited to the Revaluation Account.
• Losses are debited: Any decrease in an asset's value or increase in a liability's value is a loss and is debited to the Revaluation Account.

The final balance of the Revaluation Account represents the net profit or loss on revaluation. This profit or loss is transferred to the old partners' capital accounts in their old profit-sharing ratio.

Journal Entries:

• For increase in asset value: Asset A/c Dr. To Revaluation A/c
• For decrease in asset value: Revaluation A/c Dr. To Asset A/c
• For increase in liability value: Revaluation A/c Dr. To Liability A/c
• For decrease in liability value: Liability A/c Dr. To Revaluation A/c
• For transferring profit on revaluation: Revaluation A/c Dr. To Old Partners' Capital A/cs
• For transferring loss on revaluation: Old Partners' Capital A/cs Dr. To Revaluation A/c

Adjustment of Capitals

Sometimes, the partners agree that their capital accounts should be in proportion to their new profit-sharing ratio. This ensures that their investment in the firm aligns with their share of profits.

This adjustment is made after all other adjustments (goodwill, revaluation, reserves) have been completed.

Scenario 1: Capital is adjusted based on the new partner's capital.

1. Calculate the total capital of the new firm based on the new partner's capital and their profit share. Total Capital = New Partner's Capital × Reciprocal of their share
2. Calculate the required new capital for each old partner based on their new profit-sharing ratio. Required Capital = Total Capital × Partner's New Share
3. Compare the required capital with their actual capital (after all adjustments).
   • If a partner has excess capital, they will withdraw the surplus cash.
   • If a partner has a shortfall, they will bring in additional cash.

Scenario 2: Total capital of the new firm is pre-decided.

1. The total capital amount is already agreed upon.
2. Calculate the required capital for each partner (including the new one) by multiplying the total capital by their respective new profit share.
3. Partners then either bring in cash to meet the required amount or withdraw any excess.

Change in Profit Sharing Ratio among the Existing Partners

Reconstitution doesn't only happen when a new partner joins. Existing partners can also decide to change their profit-sharing ratio. This also leads to some partners gaining a share of future profits while others sacrificing a share.

When this happens, the gaining partners must compensate the sacrificing partners. This adjustment is typically made for the firm's goodwill. The accounting treatment is very similar to the admission of a partner:

• The gaining partner's capital account is debited.
• The sacrificing partner's capital account is credited.

Additionally, just like in an admission, a change in ratio also requires adjustments for:

• Revaluation of assets and liabilities.
• Distribution of accumulated profits and losses.
• Adjustment of capitals, if agreed upon.

All these adjustments are done in the same manner as when a new partner is admitted, ensuring that all changes are accounted for fairly before the new profit-sharing agreement takes effect.