Chapter Notes

Reconstitution of a Partnership Firm: Retirement/Death of a Partner

When a partner retires from a business or passes away, the existing partnership agreement comes to an end. This event is a form of reconstitution of the firm. The remaining partners must create a new partnership deed to continue the business, often with new terms and conditions.

The accounting process for retirement and death is very similar. In both cases, the firm must calculate the total amount owed to the outgoing partner (or their legal representatives). This involves several key adjustments for things like goodwill, the current value of assets and liabilities, and accumulated profits or losses. We also need to determine the new profit-sharing ratio and the gaining ratio for the continuing partners.

Ascertaining the Amount Due to a Retiring/Deceased Partner

Calculating the final amount payable to an outgoing partner is a detailed process. It involves adding all their entitlements and subtracting any amounts they owe to the firm.

What is included in the final amount (Credits):

• The credit balance in their capital account.
• The credit balance in their current account (if any).
• Their share of the firm's goodwill.
• Their share of accumulated profits, such as general reserves.
• Their share of any gain from the revaluation of assets and liabilities.
• Their share of profits earned from the start of the financial year up to the date of their retirement or death.
• Interest on their capital up to that date, if the partnership deed allows it.
• Any salary or commission due to them up to that date.

What is deducted from the final amount (Debits):

• The debit balance in their current account (if any).
• Their share of existing goodwill that needs to be written off.
• Their share of any accumulated losses.
• Their share of any loss from the revaluation of assets and liabilities.
• Their share of any loss incurred from the start of the financial year up to their date of retirement or death.
• Their drawings (money they have taken out for personal use) up to that date.
• Interest on their drawings up to that date, if applicable.

1. Calculate the new profit-sharing ratio and the gaining ratio.
2. Account for the treatment of goodwill.
3. Revalue assets and liabilities.
4. Adjust for any unrecorded assets and liabilities.
5. Distribute accumulated profits and losses.
6. Determine the profit or loss up to the date of retirement/death.
7. Adjust the capitals of the remaining partners, if required.
8. Settle the final amount due to the retired/deceased partner.

New Profit Sharing Ratio

The New Profit Sharing Ratio is the ratio in which the remaining partners will share future profits after a partner leaves. A continuing partner's new share is their old share plus the share they acquire from the outgoing partner.

The calculation depends on how the outgoing partner's share is divided:

• Case 1: No specific agreement (Default) If the partnership deed is silent, it is assumed that the continuing partners acquire the outgoing partner's share in their old profit-sharing ratio. In this situation, their new ratio will be the same as their old ratio relative to each other.

  Example

  Asha, Deepti, and Nisha share profits in the ratio 3:2:1. If Deepti retires, her share is gone. The new ratio between Asha and Nisha will simply be 3:1, unless they decide on something different.

• Case 2: Acquired in a specific ratio The continuing partners may agree to take the retiring partner's share in a specific, new proportion. Here, you must calculate the exact portion each partner gains and add it to their old share. New Share = Old Share + Acquired Share

• Case 3: A new ratio is specified Sometimes, the partners simply agree on what their new profit-sharing ratio will be going forward. In this case, no calculation is needed; the agreed-upon ratio becomes the new official ratio.

Gaining Ratio

The Gaining Ratio is the proportion in which the continuing partners acquire the share of the outgoing partner. This ratio is crucial because it determines how they will compensate the outgoing partner for their share of goodwill.

• When is it easy? If continuing partners acquire the share in their old profit-sharing ratio, then their gaining ratio is simply their old ratio. If the problem specifies the proportion in which they acquire the share (e.g., "in the ratio of 2:1"), that is the gaining ratio.

• When do you need to calculate it? You primarily need to calculate the gaining ratio when the new profit-sharing ratio of the continuing partners is given. The formula is: Gaining Share = New Share – Old Share

• Amit's Gain: (New Share) 3/5 - (Old Share) 5/10 = 6/10 - 5/10 = 1/10
• Gagan's Gain: (New Share) 2/5 - (Old Share) 2/10 = 4/10 - 2/10 = 2/10

The gaining ratio between Amit and Gagan is 1:2.

Treatment of Goodwill

An outgoing partner is entitled to their share of goodwill because they helped build the firm's reputation and earning capacity. The continuing partners, who will benefit from this goodwill in the future, must compensate the retiring or deceased partner. This compensation is paid by the gaining partners in their gaining ratio.

When Goodwill Does Not Appear in the Books

If goodwill is not already listed as an asset, an adjustment entry is made directly through the partners' capital accounts. The firm does not create a new "Goodwill Account" on the balance sheet.

The journal entry is:

• Debit: Gaining Partners' Capital Accounts (in their gaining ratio)
• Credit: Retiring/Deceased Partner's Capital Account

Hidden Goodwill

Sometimes, the firm agrees to pay a retiring partner a lump-sum amount that is more than the final calculated balance in their capital account (after all adjustments). This excess amount is treated as their share of goodwill and is called Hidden Goodwill.

Adjustment for Revaluation of Assets and Liabilities

At the time of retirement or death, the firm's assets may be worth more or less than their book value, and liabilities may have changed. To be fair to the outgoing partner, these assets and liabilities are revalued to their current market values.

A special account called the Revaluation Account is prepared to record these changes.

• Increases in asset values and decreases in liability values are credited to the Revaluation Account (as they are gains).
• Decreases in asset values and increases in liability values are debited to the Revaluation Account (as they are losses).

The final balance of the Revaluation Account represents the net profit or loss from this process. This profit or loss is then transferred to the capital accounts of all partners (including the one who is leaving) in their old profit-sharing ratio.

Adjustment of Accumulated Profits and Losses

The Balance Sheet may show accumulated profits (like a General Reserve) or accumulated losses (like a debit balance in the Profit and Loss Account). Since these were earned or incurred while the outgoing partner was part of the firm, they have a right (or obligation) to their share.

These amounts are transferred directly to the capital accounts of all partners in their old profit-sharing ratio.

• For accumulated profits: Debit the Reserve/Profit & Loss Account and credit all partners' capital accounts.
• For accumulated losses: Debit all partners' capital accounts and credit the Profit & Loss Account.

When a Partner Retires in the Middle of the Year

While retirement often happens at the end of a financial year, it can occur at any time. In such cases, the retiring partner's claim must include their share of profit or loss for the period between the last Balance Sheet and their retirement date.

Since it's impractical to prepare a full set of financial statements for this partial period, the profit is estimated using one of two main methods:

1. Time Basis: The profit is calculated based on the previous year's profit or an average of the last few years' profits, adjusted for the time period.
   • Formula: (Last Year's/Average Profit) x (Months until retirement / 12) x (Retiring Partner's Share)
2. Turnover or Sales Basis: The profit is estimated based on the sales made during the period. The profit rate is usually taken from the previous year.
   • Formula: (Sales until retirement) x (Previous Year's Profit Rate) x (Retiring Partner's Share)

The retiring partner's share of this estimated profit is usually recorded by debiting a Profit & Loss Suspense Account and crediting the retiring partner's capital account. This suspense account is later closed by transferring the amount to the gaining partners' capital accounts in their gaining ratio.

Disposal of Amount Due to Retiring Partner

Once the final amount due to the outgoing partner is calculated, the firm must settle it. The method of settlement is usually specified in the partnership deed.

The common methods are:

• Lump-Sum Payment: The entire amount is paid immediately in cash or by cheque.
• Transfer to Loan Account: If the firm doesn't have enough cash, the amount is transferred to a Retiring Partner's Loan Account. The firm then pays this loan back over time, with interest.
• Partial Payment: A portion is paid in cash, and the rest is transferred to a loan account.

When the amount is paid in installments from the loan account, each payment includes a portion of the principal amount and the interest due on the outstanding balance.

Adjustment of Partners' Capitals

After a partner's retirement, the remaining partners may decide to adjust their capital accounts to be proportional to their new profit-sharing ratio. This ensures their capital contributions align with their new stake in the firm.

There are three common scenarios for this adjustment:

1. When the total capital of the new firm is specified: The total capital is divided among the continuing partners in their new profit-sharing ratio. Partners with a surplus will withdraw cash, and those with a deficit will bring in cash.
2. When the total capital is not specified: The total capital of the new firm is considered to be the sum of the adjusted capital balances of the continuing partners. This total is then redistributed according to the new profit-sharing ratio, and partners either bring in or withdraw cash to meet their new capital requirements.
3. When continuing partners contribute to pay the retiring partner: The amount payable to the retiring partner is added to the existing capital balances of the continuing partners. This sum becomes the new total capital. This total is then divided according to the new ratio to determine how much cash each continuing partner needs to bring in to pay off the retiring partner and adjust their own capital simultaneously.

Death of a Partner

The accounting treatment for the death of a partner is almost identical to that of retirement. The main difference is that the amount due is calculated up to the date of death and is transferred to the Deceased Partner's Executor's Account, not a loan account. The firm then settles the amount with the legal executor of the deceased partner.

The biggest challenge is calculating the deceased partner's share of profit for the period between the last balance sheet and the date of death. This is done using the same time-based or sales-based methods as described for mid-year retirement. The deceased partner's share is credited to their capital account through the Profit & Loss Suspense Account. All other adjustments for goodwill, revaluation, and accumulated profits are handled in the same way as for retirement.