Ch -3 : RECONSTITUTION OF A PARTNERSHIP FIRM-ADMISSION OF A PARTNER

Introduction

Partnership is the result of an agreement between partners for sharing profit of the business.Any changes in the relationship  among partners, the

existing  agreement comes to end and a new agreement comes into being.

Reconstitution of a partnership means change in the nature of relationship amongst members.

Different Modes/ Occasion of  Reconstitution
Reconstitution of the firm can have different form,or rather it takes place on different occasions as follows:-

  1. Admission of a new partner
  2. Change in the profit sharing ratio of existing partners
  3. Retirement of a partner
  4. Death of a partner
1-ADMISSION OF A PARTNER

Inclusion of a person  as a new partner  to an existing partnership firm is called Admission of a Partner.A firm requires additional capital or managerial help or both for the expansion of its

business a new partner may be admitted.When the time of admission the partnership is reconstituted  with a new fresh agreement.The new person admitted is called an incoming partner.

Effect of a Admission of a New Partner
An incoming partner acquires two main rights in the firm, they are:-

  • Right to share the asset of the firm              – For this he should bring Capital
  • Right to share the profit of the firm             – For this he should bring Goodwill/Premium

Accounting adjustments on Admission of  a Partner

  1. Capital of the new partner
  2. Calculation of new profit sharing ratio
  3. Calculation of sacrificing ratio
  4. Treatment of Goodwill
  5. Revaluation of assets and liabilities
  6. Distribution of reserves and accumulated profits and losses
  7. Adjustment of capital accounts  of  partners
A-Capital  of New partner

At the time of admission an incoming partner brings capital in cash or assets.

Cash / Asset   A/c          Dr
To New partner’s capital A/c

(Cash or assets brought as capital)

Ex:  Cash     A/c   Dr       50,000  
Land     A/c  Dr    100,000 
To New Partner’s capital    A/c   1,50,000

                                   

                                               

B-Calculation of New profit sharing ratio

New profit sharing ratio is the ratio in which all partners,including new partner share the future profit and losses.The new profit sharing ratio will be calculated by how the new partner acquires his share from the old partners

How to Add and subtract fractions with unlike denominators

Subtracting Fractions

Adding Fractions

  1. New partner gets  share  from total  profit (Ex:   1/5 from total profit) –
    A and B are Partners sharing profits and losses in the ratio of 3:2. C is admitted for 1/6th share of profits.calculate new profit sharing ratio of the partners.

              New profit sharing ratio of old partner = remaining share X Old profit sharing ratio of partner

  1. New partner may acquire equally with the old partner:-
    A and B are partners sharing profits and losses in the ratio of 5:3. C is admitted in the firm with 1/5 share in the profits which he acquired equally from both.ie ,1/10 from A and 1/10 from B. Calculate the new profit sharing ratio.

              New Ratio of old partner =  Old ratio  –  portion given to new partner

  1. New partner acquire it in some agreed ratio:-
    A and B are partners sharing profits in the ratio of 3:1. C is admitted in the firm with 1/8 share, which he acquires 1/32 from A and 3/32 from B. calculate new profit sharing ratio.

              New Ratio of old partner =  Old ratio  –  portion acquired by new partner

  1. New partner acquire it wholly from one partner
    A and B are partners in a firm sharing profits and losses in the ratio of 4:1, C is admitted into partnership with 1/4th share in profits which he acquires wholly from A.Calculate new profit sharing ratio.

              New Ratio of that partner =  Old ratio  –  portion given to new partner

  1. New partner acquire it in the form of certain fraction of old partners share in profit
    A and B are partners sharing profits in the ratio of 3:1. C is admitted as a partner in the firm. A surrendered 1/32 of his share and B 3/32 of his share in favour of C. Calculate the new profit sharing ratio.

New Ratio of old partner =  Old ratio  –  portion given to new partner(old ratio X Fraction    given to new partner)

Calculation of New Profit sharing Ratio

newly admitted partner is required to compensate the old partners for his  right to share in the future profits of the firm. The compensation or premium brought by new partner must be shared by the old partners in the sacrificing ratio.

Sacrificing ratio = Old ratio  of a partner – New ratio of a partner

Some times ,while the admission of a new partner, old partners rearrange their shares in profits.In such a way that some of the old partners may also gain additional shares in profits.in such a case , the gaining old  partner will also be required to compensate the partner who makes the sacrifice.

      Gaining Ratio = New share  –  Old share

Calculation of Sacrificing Ratio

Calculation of New Profit Sharing Ratio and Sacrificing Ratio – Illustration 1:

Calculation of New Profit Sharing Ratio and Sacrificing Ratio – Illustration 2:

Calculation of New Profit Sharing Ratio and Sacrificing Ratio – Illustration 3:

D-Treatment of Good will

A well established business can earn more profit compared to a newly set up business because of its good name,reputation  and business connections.The monetary value of such advantage is known as Goodwill.

It can be defined as “ the present value of a firm’s anticipated excess earnings”. 

The excess super and extra ordinary profit earned is termed as Goodwill.

Factors affecting the value of goodwill

  1. Location of business
  2. Nature of business
  3. Efficiency of management
  4. Time factor
  5. Market situations
  6. Special advantages

Need for valuation of Goodwill

Arises Under the following circumstances:-

  1. Change the profit sharing ratio of the existing partners
  2. Admission of a partner
  3. Retirement of a partner
  4. Death of a partner
  5. Dissolution / sale of partnership
  6. Amalgamation of firms.

Methods of valuation of goodwill

        Usually the method of valuation of goodwill will be mentioned in the partnership deed.The important methods are:-

  1. Average profit method
  2. Weighted average profit method
  3. Super profit method
  4. Capitalisation method
    1. Capitalisation of average profit
    2. Capitalisation of Super profit

Goodwill = Average profit  X  No.of years purchase

                Average profit = Total profit for past few years
No.of years

Ex:  profits for 3 years, 30,000 , 40,000 , 20000, GW is 3 year purchase of Average profit
Average Profit =30000+40000+200003=30000
Goodwill = Ap X 3 year Purchase of AP,  
= 30000 X 3 = 120000
  • Loss also be considered ( 40000+30000-1000(loss)   AP= 60000)
  • Abnormal Gain or Loss not included in profit   (Total Profit 37500, abnormal gain 2500,so ,profit  is 37500 – 2500 =35000)
2-Weighted average profit method

In simple average profit method the weightage  given for all years is equal.It is considered to be better to give higher weightage to profit in recent years  than those of  the earlier years.

here weight like 1,2,3…given to the respective years(Weighted average method should be used only if specified)

                          Goodwill = Weighted AP  X No.of years Purchase

                            Weighted AP =  Product total / Weight total

Ex:   

YearProfitWeightProduct(Profit X Weight)
201150001      (Assign the weight)5000
20128000216000
Total weight = 3Total product = 21000

                      Weighted AP =    21000/3 = 7000

                      GoodWill = 7000  X No.of year purchase

3-Super Profit Method

The goodwill under the super profit method is ascertained by multiplying the super profits by certain number of years’ purchase.Super profit is the excess of actual profit over the normal profit.

Normal profit is termed as normal rate of return on capital employed .

Steps involved in the calculation of Goodwill

  1. Calculate the Average profit
  2. Ascertain  the Normal profit,  Normal profit = Capital employed  X normal rate of return
  3. Calculate the Super Profit , Super profit = Average Profit – Normal Profit

       Calculate the Goodwill by multiplying the super profit by the decided number of years.

4-Capitalisation Method

Under this method Goodwill can be calculated by

  1. Capitalising of average profit
  2. Capitalising Super profit
a)Capitalising average profit

Goodwill is ascertained by deducting the Net tangible asset  from the total capitalised value  of average profit.

ngible asset = Total tangible asset – liabilities outside

Capitalised value is calculated by capitalising the Average profit on the basis of Normal rate of return

Steps involved in the calculation of Goodwill

  1. Find out the average profits of the past few years
  2. Capitalise the average profits on the basis of normal rate of return.This will give total capitalised value of business.

  Capitalised value = average profit  X Normal rate of return 

  1. Ascertain the actual capital employed by deducting the outsiders liability from total assets(excluding goodwill)
  2. Compute the value of Goodwill by deducting net asset from the total value of business.
b)Capitalisation of Super profit

Here total value of business is calculated by capitalising the value of super profits on the    basis of normal rate of return.

Steps –Calculating Goodwill

  1. Calculate the average profit
  2. Calculate the total capital employed (Total assets-Out sider’s liability)
  3. Calculate the normal profit on capital employed at the Normal rate of return
    Normal Profit =  capital employed  X Normal rate of return
  1. Calculate super profit ( Average profit – Normal profit)
  2. Find out Goodwill = Super profit X Normal rate of return
Accounting Adjustment of Goodwill

When a new person is admitted , he is required to compensate the existing partners for giving him a share of future profits. For this he has to make payment to them,it is known as Share of Goodwill or Premium.

rnatively  he may agree that Goodwill accounts be raised in the books by giving necessary credit to the old partners. Thus Goodwill can be treated in two ways, 

They are:-

  1. By premium Method
  2. Revaluation Method
Premium Method

This method is followed when the new partner pays his share of goodwill in Cash.The amount of premium brought by the new partner is shared by the existing partners in the ratio in which they sacrifice their profit share.

  1. Goodwill paid privately

              Sometimes ,the new partner brings in his share of goodwill in cash and the same is paid to old partners privately, ie outside the business, no entry is to be made in the books.

  1. The new partner brings in his share of goodwill in cash which is retained in the business

                             Journal Entries :-

  1.   Cash         a/c          Dr

                   To Goodwill    a/c

(The amount actually brought in by new partner as goodwill)

  1.   Goodwill      a/cc     Dr

                                     To  Old partners capital  A/c (Individually)

(goodwill distributed among the old partners in their sacrificing ratio)

                 Or

                               Cash           A/c          Dr

                        To Old Partners capital   A/c(Individually)

(Cash brought in for goodwill credited to old partners in their sacrificing ratio) 

Note : The goodwill/premium brought in by the incoming partner is shared by the old partners in their sacrificing ratio because they forgo their future profits in this ratio.

  1. The new partner  brings in his share of goodwill in cash and the same in full or part is withdrawn by the old partners

                     Journal entries:-

A – Cash         A/c     Dr         –  Bring the Goodwill 

          To  Goodwill     A/c   

B –          Goodwill    A/c   Dr         – Sharing by old partners

To Old Partners capital A/c

C  –         Old partners’ capital    A/c         – Withdrawn by old  partners

To  Cash               A/c

                            (The amount of goodwill withdrawn by the old partners)

4- Share of Goodwill brought in kind

In this situation, the new partner brings in his share of goodwill in the form of assets, instead of cash

Journal entries:-

A – When capital and Goodwill are brought in the form of assets

Assets (individually)     A/c   Dr

To new partners capital  A/c

To Goodwill            A/c

            (Assets brought in by the new partner towards towards capital and share of goodwill)

B-To share Goodwill among the old partners

                        Goodwill     A/c    Dr

                        To Old partners capital    A/c  (Individually)

           (Goodwill amount transferred to old partners’ capital account in the sacrificing ratio)

5-New partner brings in only a portion of the goodwill in cash

       Sometimes ,the new partner brings only a portion of goodwill.The remaining   amount adjusts from his capital account.

             Journal entries:-

a-For the amount of goodwill brought in cash

Cash      A/c     Dr

To Goodwill a/c

(For the amount of goodwill brought in cash )

b-For transferring the Goodwill (Share of new partner) Old partners

              Goodwill         A/c    Dr -Amount actually brought in cash

               New Partner’s Capital    A/c -Remaining amount of Goodwill

            To Old partners capital   A/c -Total premium to old partners 

                                 (Goodwill shared by old partners in the sacrificing ratio)

6-New Partner not in a position to bring Goodwill 

Some times ,the new partner may not be in a position to bring cash for his share of goodwill.in such a situation the new partner’s capital account is debited for his share of goodwill.

Journal entry:-

For transferring new partner’s share of goodwill to old partners

New partner’s Capital       A/c

To Old partners Capital A/c   – Individually

(For sharing goodwill by the old partners in the sacrificing ratio)

7-Goodwill existing in the books at the time admission

Goodwill already appearing in the books is written off by debiting old partners capital accounts in the old profit sharing ratio.

Old partners’ Capital    A/c   Dr in old ratio

To Goodwill   A/c GW existing in the books

Again ,if the new partner brings his share of Goodwill, it should be credited to old partners in the sacrificing ratio.

8-Hidden Goodwill

If the Value of Goodwill of the firm is not specifically given in the question, it is to be inferred from the arrangement of the capital and profit sharing ratio.

Find out the total capital by multiplying the incoming partner’s capital and profit sharing ratio.

Revaluation Method

This method is followed when the new partner does not brings in his share of goodwill in cash. In such a situation,the new Goodwill account raised in the books of accounts by crediting the old partners in the old profit sharing ratio.

There are two possibilities:-

  1. No goodwill appears in books at the time of admission
  2. Goodwill already exists in the books.

A – No goodwill appears in books at the time of admission

In this method the Goodwill account must be raised at its full value.

Goodwill     A/c  Dr

       To Old Partners’ capital Account

(Goodwill raised at full value in the old profit sharing ratio)

B – Goodwill already exists in the books

If the books already show some balance in the Goodwill account,the adjustment for Goodwill in the old partners capital account shall be made only for the difference between the agreed value and the amount of Goodwill appearing.

  1. When the value of goodwill appearing in the books is less than agreed value 

Agreed value                      – 40000

In the books of accounts – 30000 

         Goodwill      A/c      Dr   10000

                 To Old partners capital A/c

(Amount of goodwill raised from book value to agreed value)

  1. When the value of GW appearing in the books is more than the Agreed value

Agreed value    –     40000

In the Books of accounts  – 45000

       Old partners capital A/c      Dr   5000

                To Goodwill     A/c                      5000

(Goodwill brought down to its agreed value)

Note: Goodwill shall appear in the B/S at Rs. 40000 in both cases.

Normally,when goodwill is raised it will be shown in the B/S at its agreed value, sometimes the partners may decide that the goodwill should not appear in the firm’s balance sheet,then it has to be written off.

a-GW Raised in the books

Goodwill A/c Dr           – Full value credited to old partners cap. A/c in OR

      To Old Partner’s  Capital A/c

b-GW Writeoff

All Partners   Capital A/c     Dr

To Goodwill       A/c            – Full value written off to all partners                    including new partner in the new profit sharing ratio.

The net effect of such treatment is old partners capital account credited in the ratio of their sacrifice, and the goodwill shows nil balance.

E-Revaluation of Assets and liabilities

On admission of a new partner assets and liabilities are to be revalued and the result (profit/loss)should be transferred to old partners in their old profit sharing ratio. For this   a revaluation   A/c or P&L adjustment a/c is prepared.It is a nominal account.

PROFORMA OF REVALUATION ACCOUNT

ParticularsAmountParticularsAmount
Decrease in the value of assets
Increase in the Value of Liability
Unrecorded liability brought in to a/c

Balance –Profit on Revaluation
To old partner’s Capital A/c(Individually)
xxx
xxx
xxx

xxx
Increase in Value of Assets
Decrease in value of Liability
Unrecorded Assets brought in to a/c
Balance – loss – on revaluation
To old partner’s Capital A/c(Individually)
xxx
xxx
xxx

xxx
xxxxxx

Note : Assets and liabilities will be shown at their revised value in the balance sheet prepared immediately after the admission of the new partner.

6-Adjustment for Reserve and Accumulated Profit/Loss

At the time of admission Reserve or Undistributed Profit/Accumulated Losses of the previous years appearing on the liability side (if loss -Asset side) of balance sheet should be transferred to the capital accounts of old partners in their old profit sharing ratio.

This is to be done even if the question in silent about this.

Journal entries

1-For Reserve and undistributed Profits

Reserve/Profit & loss A/c Dr

        To Old partner’s capital A/c

(Reserve or Profit transferred to old partner’s capital A/c in their Old Profit sharing Ratio)

2-For accumulated Losses

Old Partners capital A/c Dr

        To Profit & Loss  A/c

(Accumulated losses transferred to old partner’s capital A/c in their Old Profit sharing Ratio)

7-Adjustment of capital Accounts of partners

At the time of admission of new partner the capitals of all partners are adjusted in their profit sharing ratio.This are done in two ways:-

1-Adjustment of old partners capital accounts on the basis of incoming partner’s capital.

If the capital of new partner is given,the same can be used as a base for calculating the new capitals of old partners.on this basis, the entire capital of the firm can be ascertained and the capital of each partner is arrived at according to the profit Sharing ratio. Capitals should be arranged after all adjustments are made.

Ex:  A and B , ratio is 3:2,with capitals of 80,000 and 65,000. they admitted C with 1/6 share for a capital of Rs.30,000

So. Total capital is 30000×6/1=1,80,000

A’s new share =5/6 x 3/5=3/6,  capital is 180,000×3/6=90,000

B’s new share = 5/6 x 2/5=2/6, capital is 1,80,000x 2/6=60,000.  

Capitals ,After all adjustments A=80000 – 90000 = -10000, he should bring Rs 10000

                                                    B=65000 – 60000 = 5000, he can withdraw Rs 5000

2-Bringing in proportionate capital by the incoming partner based on the capitals of existing partners.

If the new partner is to bring in proportionate capital,the amount will be ascertained on the basis of the total capitals (after all adjustments are made)of the existing partners and the total of their share of profits.

Steps to ascertain the capital to be brought in by the incoming partner:-

1-Totalup the capital of old partners(after all adjustments for Goodwill,revaluation etc)

2-Add Up the new profit sharing right of old partners

3-Consider the total capital using new profit sharing ratio

4-Ascertain the capital to be brought in by the incoming partner according to his profit sharing rights.

Ex: A and B, capitals of 20,000 and 16,000 with Profit sharing ratio 3:2, C admitted with 1/5 share

The share of A&B , (remaining share)=4/5,The capital of A&B is 20,000+16,000=36,000

So ,total capital of the firm is 36000 x 5/4=45,000. C will bring his share 45,000 x 1/5 = 9000.

Change in profit sharing ratio among the existing partners

Sometimes,the existing partners may decide to change their profit sharing ratio.in such a case ,those who gain must compensate the others who have made the sacrifice on account of change in profit sharing ratio.

Ex: A and B, with PSR of 2:4, they change PSR to 3:2, the Goodwill is valued at 60,000

Goodwill as per old PSR – A -20000, B – 40000

Goodwill as per New PSR – A -36000, B – 24000

Gain of A(36000-20000=16000) , Sacrifice of B(40000-24000 = 16000)

Adjusting Journal entry:-

A’s capital a/c           Dr – 16000

          To B’s capital A/c      16000