As we know that Partnership is an agreement between the partners or members of the firm for sharing profits and losses of the business carried on by all or any of them acting for all. Any change in this agreement amounts to the reconstitution of the partnership firm.
Reconstitution of partnership firm usually takes place in any of the following situations:
When a business enterprise requires additional capital or managerial help or both for the growth and expansion of the business it may admit a new partner to supplement its existing resources. So, admission of a new partner is required for the following reasons:
According to Sec. 31, Indian Partnership Act, 1932, a new partner can be admitted into the firm only with the consent of all the existing partners unless otherwise agreed upon. Admission of a new partner means reconstitution of the firm. It is so because the existing agreement comes to an end and a new agreement comes into effect.
A newly admitted partner acquire s two main rights in the firm:
Section 31, Indian Partnership Act, 1932, further specifies that the new partner is not liable for any debts incurred by the firm before he became a partner. New partner, however, will become liable if:
A new partner brings an agreed amount of capital either in cash or in-kind and he also contributes some additional amount known as premium or goodwill. This is done primarily to compensate the existing partners for the loss of their share in the profits of the firms.
Adjustment at the Time of Admission of a New Partner:
The new partner may acquire his share from the old partners in any of the following situations:
1. If only the ratio of the new partner is given, then in the absence of any other agreement or information, it is assumed that the old partners will continue to share the remaining profits in the old ratio.
Example: X, and Z are partners sharing profits in the ratio 3:2:1 respectively. A is admitted in the firm as a new partner with 1/6th share. Find the new profit sharing ratio.
Answer:
Let total profit = 1
A’s share = 1/6th
Remaining Profit = 1 – 1/6 = 5/6
Old partners share this remaining profit in the old profit sharing
2. If the new partner acquires his share of profit from the old partners equally. In that case, the new profit sharing ratio of the old partner will be calculated by deducting the sacrifice made by them from their existing share of profit.
Example: Varun and Daksh are partners sharing profits and losses in the ratio 5:3. They admit Dhruv as a partner for 1/4th share, which he acquires equally from Varun and Daksh. Calculate the new profit sharing ratio.
Answer:
Dhruv1s share = 1/4
Share acquired by Dhruv from Varun
Share acquired by Dhruv from Daksh
3. In the new partner acquire his share of profit from the old partners in a particular ratio. In that case, the new profit sharing ratio of the old partners will be calculated by deducting the sacrifice made by them from their existing share of profit.
Example: Noni and Pony are partners, sharing profits in the ratio of 7:5. They admit Tony as new partner for 1/6th share which he takes 1/24th from Noni and 1/8th from Pony. Calculate the new profit sharing ratio.
Answer:
4. If the old partners surrender a particular fraction of their share in favour of the new partner. In that case, the new partner’s share is calculated by adding the surrendered portion of the share by the old partners. Old partners’ share is calculated by deducting the surrendered portion from their old ratio.
Example: Anu and Priti are partners in firm sharing profits in the ratio of 5:3. Anu surrenders 1/20th of her share and Priti surrenders 1/24th of her share in favour of Kapil, a new partner. Calculate the new profit sharing ratio.
Answer:
Anu’s share = 5/8
5. If the new partner acquires his share of profit from only one partner. In that case, the new profit sharing ratio of the old partner will be calculated by deducting the sacrifice made by one partner from his existing ratio.
Example: Akshay and Anshul are partners in a firm sharing profits in a 4: 1 ratio. They admitted Shikha as a new partner for 1/4 share in the profits, which she acquired wholly from Akshay. Calculate the new profit sharing ratio.
Answer:
Akhay’s share = 4/5
The ratio in which the old partners have agreed to sacrifice their shares in profit in favour of a new partner is called the sacrificing ratio. This ratio is calculated by taking out the difference between the old profit sharing ratio and the new profit sharing ratio.
Sacrificing Ratio = Old Ratio – New Ratio
Goodwill is the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits earned by other similar firms belonging to the same industry. In other words, a well-established business develops an advantage of good name, reputation and wide business connections. This helps the business to earn more profits as compared to newly set-up business. This advantage in monetary terms called ‘Goodwill’. It arises only if a firm is able to earn higher profits than normal.
Characteristics of Goodwill
Goodwill is an intangible asset, so it is very difficult to calculate its exact value. There are various methods for the valuation of goodwill in the partnership, but the value of goodwill may differ in different methods. The method by which the value of goodwill is to be calculated may be specifically decided among all the partners.
The methods followed for valuing goodwill are:
1. Average Profit Method
Goodwill is calculated on the basis of the number of past years profits. In this method, the goodwill is valued at an agreed number of ‘years’ purchase of the average profits of the past few years.
Steps:
In other words:
Goodwill = Actual Average Profit × No. of Years Purchased
→ Weighted Average Profit Method
Sometimes, if there exists an increasing or decreasing trend, it is considered to be better to give a higher weightage to the profits to the recent years than those of the earlier years. This method is an extension of the average profit method.
Steps:
2. Super Profit Method
Under this method, goodwill is valued on the basis of excess profits earned by a firm in comparison to average profits earned by other firms. When a similar type of firm gets a return as a certain percentage of the capital employed, it is called ‘normal return’. The excess of actual profit over the normal profit is called ‘Super Profits’. To find out the value of goodwill, Super profit is multiplied by the agreed number of year’s purchase.
Steps
3. Capitalization Methods
(a) by capitalizing the average profits
(b) by capitalizing the super profits
(a) Capitalization of Actual Average Profit Method
Steps:
(b) Capitalisation of Super Profit Method
Steps:
To compensate old partners for the loss (sacrifice) of their share in profits, the incoming partner, who acquire his share of profit from the old partners brings in some additional amount termed as a share of goodwill.
Goodwill, at the time of admission, can be treated in two ways:
1. Premium Method
The premium method is followed when the incoming partner pays his share of goodwill in cash. From the accounting point of view, the following are the different situations related to the treatment of goodwill:
(a) Goodwill (Premium) paid privately (directly to old partners)
(b) Goodwill (Premium) brought in cash through the firm
1. Cash A/c or Bank A/c Dr.
To Goodwill A/c
(For the amount of Goodwill brought by new partner)
2. Goodwill A/c Dr.
To Old Partner’s Capital A/c
(For the amount of Goodwill distributed among the old partners in their sacrificing ratio)
Alternatively:
1. Cash A/c or Bank A/c Dr.
To New Partner’s Capital A/c (For the amount of Goodwill brought b> a new partner)
2. New Partner’s Capital A/c Dr.
To Old Partner’s Capital A/c’s (For the amount of Goodwill distributed among the old partners in their sacrificing ratio)
3. If old partners withdrew goodwill (in full or in part) (if any)
Old Partner’s Capital A/c’s Dr.
To Cash A/c or Bank A/c
(For the amount of goodwill withdrawn by the old partners)
When goodwill already exists in books
If the goodwill already exists in the books of firms and the incoming partner brings his share of goodwill in cash, then the goodwill appearing in the books will have to be written off.
Old Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For Goodwill written-off in old ratio)
After the admission of the partner, all partners may decide to maintain the Goodwill Account in the books of accounts.
Goodwill A/c Dr.
To All Partner’s Capital A/c’s (For Goodwill raised in the new firm after admission of a new partner in new profit sharing ratio)
2. Revaluation Method
If the incoming partner does not bring in his share of goodwill in cash, then this method is followed. In this case, the goodwill account is raised in the books of accounts. When goodwill account is to be raised in the books there are two possibilities:
(a) No goodwill appears in the books:
Goodwill A/c Dr.
To Old Partner’s Capital A/c’s (For Goodwill raised at full value in the old ratio)
If the incoming partner brings in a part of his share of goodwill. In that case, after distributing the amount brought in for goodwill among the old partners in their sacrificing ratio, the goodwill account is raised in the books of accounts based on the portion of premium not brought by the incoming partner.
Example: X and Y are partners sharing profits in the ratio of 3: 2. They admit Z as a new partner. 1/4th share. The sacrificing ratio of X and Y is 2: 1. Z brings Rs. 12,000 as goodwill out of his share of Rs. 18,000. No goodwill account appears in the books of the firm.
Answer: Journal
(b) When goodwill already exists in the books:
1. When the value of goodwill appearing in books is equal to the agreed value:
[No Entry is Required]
2. If the value of goodwill appearing in the books is less than the agreed value:
Goodwill A/c Dr.
To Old Partner’s Capital A/c’s (For Goodwill is raised to its agreed value)
3. If the value of goodwill appearing in the books is more than the agreed value:
Old Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For Goodwill brought down to its agreed value)
→ If partners, after raising Goodwill in the books and making necessary adjustments decide that the goodwill should not appear in the firm’s balance sheet, then it has to be written off.
All Partners’ Capital A/c’s Dr.
To Goodwill A/c (For Goodwill written off)
→ Sometimes, the partners may decide not to show goodwill account anywhere in books.
New Partner’s Capital A/c Dr.
To Old Partner’s Capital A/c (For adjustment for New Partner’s Share of Goodwill)
Hidden or Inferred Goodwill
1. To find out the total capital of the firm by new partner’s capital and his share of profit.
Example: New partner’s capital for 1/4th share is Rs. 80,000, the entire capital of the new firm will be
80,000 × 4/1 = Rs. 3,20,000
2. To ascertain the existing total capital of the firm: We will have to ascertain the existing total capital of the new firm by adding the capital (of all partners, including new partner’s capital after adjustments, if any excluding goodwill)
→ If assets and liabilities are given:
Capital = Assets (at revalued figures) – Liabilities (at revalued figures)
3. Goodwill = Capital from (1) – Capital from (2)
Generally, this method is used, when the incoming partner does not bring his share of goodwill in cash. Here, we find out the total goodwill of the firm. After that, we can find out the new partner’s share of goodwill and treat accordingly.
1. For Undistributed Profits, Reserves etc.
(For distribution of accumulated profits and reserves to old partners in old profit sharing ratio)
General Reserves A/c Dr.
Reserve fund A/c Dr.
Profit and Loss A/c Dr.
Workmen’s Compensation Fund A/c Dr.
To Old Partner’s Capital A/c’s
(For distribution of accumulated profits and reserves to old partners in old profit sharing ratio)
2. For Undistributed Losses:
Old Partner’s Capital A/c’s Dr.
To Profit and Loss A/c
(For distribution of accumulated losses to old partners in old profit sharing ratio)
Revaluation of Assets and Reassessment of Liabilities: Revaluation of Assets and Reassessment of Liabilities is done with the help of ‘Revaluation Account’ or ‘Profit and Loss Adjustment Account’.
The journal entries recorded for revaluation of assets and reassessment of liabilities are following:
1. For increase in the value of an Assets
Assets A/c Dr.
To Revaluation A/c (Gain)
2. For decrease in the value of an Assets
Revaluation A/c Dr.
To Assets A/c (Loss)
3. For appreciation in the amount of Liability
Revaluation A/c Dr.
To Liability A/c (Loss)
4. For reduction in the amount of a Liability
Liability A/c Dr.
To Revaluation A/c (Gain)
5. For recording an unrecorded Assets
Unrecorded Assets A/c Dr.
To Revaluation A/c (Gain)
6. For recording an unrecorded Liability
Revaluation A/c Dr.
To Unrecorded Liability A/c (Loss)
7. For the sale of unrecorded Assets
Cash A/c or Bank A/c Dr.
To Revaluation A/c (Gain)
8. For payment of unrecorded Liability
Revaluation A/c Dr.
To Cash A/c or Bank A/c (Loss)
9. For transfer of gain on Revaluation if the credit balance
Revaluation A/c Dr.
To Old Partner’s Capital A/c’s (Old Ratio)
10. For transfer of loss on Revaluation if debit balance
Old Partner’s Capital A/c’s Dr.
To Revaluation A/c (Old Ratio)
1. When the new partner brings in proportionate capital OR On the basis of the old partner’s capital.
(a) Calculate the adjusted capital of old partners (after all adjustments)
(b) Total capital of the firm
= Combined Adjusted Capital × Reciprocal proportion of the share of old partners
(c) New Partner’s Capital
= Total Capital × Proportion of share of a new partner.
2. On the basis of the new partner’s capital:
(a) Total Capital of the firm = New Partner’s Capital × Reciprocal proportion of his share.
(b) Distribute Total Capital in New Profit Sharing Ratio.
(c) Calculate adjusted capital of old partners.
(d) Calculate the difference between New Capital and Adjusted Capital.
Change in Profit Sharing Ratio among the Existing Partners
Sometimes the existing partners of the firm may decide to change their profit sharing ratio. In such a case, some partner will gain in future profits and some will lose. Here the gaining partners should compensate the losing partners unless otherwise agreed upon. In such a situation, first of all, the loss and gain in the value of goodwill (if any) will have to adjust.
1. Goodwill A/c Dr.
To Partner’s Capital A/c’s (For raising the amount of Goodwill in old ratio)
2. Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For writing off the amount of Goodwill in New Profit sharing ratio)
Alternatively:
Gaining Partner’s Capital A/c’s Dr.
To Losing Partner’s Capital A/c’s (For adjustment due to change in profit sharing ratio)
47 videos|122 docs|56 tests
|
1. What are the different modes of reconstitution of a partnership firm? |
2. What is the process of admitting a new partner in a partnership firm? |
3. How is the new profit sharing ratio determined when a new partner is admitted? |
4. What is goodwill and how is it accounted for during the reconstitution of a partnership firm? |
5. How are accumulated profits or losses adjusted during the reconstitution of a partnership firm? |
|
Explore Courses for Commerce exam
|