Reconstitution of a Partnership Firm : Retirement/Death of a Partner Chapter Notes | Accountancy Class 12 - Commerce PDF Download

Introduction

When a partner retires or dies, the existing partnership arrangement is changed and the firm continues under a revised agreement. In both situations, the essential accounting steps are similar: determine the amount payable to the outgoing partner (or to the legal representatives of a deceased partner), adjust for goodwill, revalue assets and liabilities, distribute accumulated reserves or losses, and fix a new profit-sharing ratio among the continuing partners. The continuing partners must also determine the gaining ratio to decide how they will compensate the outgoing partner for the share transferred to them.

Ascertaining the Amount Due to Retiring/Deceased Partner

The total amount payable to a retiring partner or to the executors of a deceased partner normally comprises the following components and adjustments.

Components to be credited to the outgoing partner

• Credit balance of the partner's capital account
• Credit balance of current account, if any
• Share of goodwill
• Share of accumulated profits (reserves)
• Share in gain on revaluation of assets and liabilities
• Share of profit up to the date of retirement/death
• Interest on capital (if provided in the deed) up to the date
• Salary/commission due up to the date

Deductions from the amount due

• Debit balance of the current account, if any
• Share of goodwill written off, if applicable
• Share of accumulated losses
• Share of loss on revaluation of assets and liabilities
• Share of loss up to the date of retirement/death
• Drawings up to the date
• Interest on drawings (if applicable) up to the date

The main accounting tasks to be completed when a partner retires or dies are:

• Determine the new profit-sharing ratio among continuing partners and calculate the gain ratio.
• Determine the treatment of goodwill.
• Prepare a Revaluation Account to record changes in asset and liability values and to bring in any unrecorded items.
• Transfer accumulated profits or losses to partners' capital accounts in the old profit-sharing ratio.
• Compute the share of profit or loss for the intervening period (from the last balance sheet date to the date of retirement/death).
• Adjust partner capital accounts and settle the amount due to the outgoing partner as per the agreement.

New Profit-Sharing Ratio

The new profit-sharing ratio is the ratio in which the continuing partners agree to share future profits after a partner's retirement or death. It depends on whether and how the outgoing partner's share is taken over by the continuing partners.

Typical situations:

(a) If the continuing partners take over the outgoing partner's share in the old profit-sharing ratio, the new ratio among continuing partners remains the same as their old ratio. No separate calculation is needed. For example, if Asha, Deepti and Nisha share profits in 3:2:1 and Deepti retires, Asha and Nisha will continue in the ratio 3:1 unless they agree otherwise.

(b) If the continuing partners agree to take the outgoing partner's share in a specified proportion different from the old ratio, compute each continuing partner's new share as:

New share of a continuing partner = Old share + Acquired share from outgoing partner

Example: Naveen, Suresh and Tarun share 5:3:2. Suresh retires. Naveen and Tarun acquire Suresh's share in the ratio 2:1. Their new shares become: Naveen = 5 + 2 = 7; Tarun = 2 + 1 = 3. So new ratio = 7:3.

(c) The partners may simply agree a specific new ratio. That agreed ratio becomes the new profit-sharing ratio.

Gaining Ratio

• The gaining ratio shows in what proportion the continuing partners gain the outgoing partner's share.
• If the continuing partners take the outgoing share in their old ratio, the gaining ratio equals their old profit-sharing ratio.
• If the new shares of the continuing partners are given, calculate the gaining ratio by subtracting each partner's old share from their new share:

Gaining share of a continuing partner = New share - Old share

Worked example: Amit, Dinesh and Gagan share profits in 5:3:2. Dinesh retires. Amit and Gagan agree on the new ratio 3:2. Gaining ratio = (new - old) for Amit and Gagan, respectively = (3/5 - 5/10) and (2/5 - 2/10), which simplifies to 1:2. Amit therefore gains 1/3 and Gagan gains 2/3 of Dinesh's share.

Example: Madhu, Neha and Tina are partners sharing profits in the ratio of 5:3:2. Calculate new profit-sharing ratio and the gain ratio if
1. Madhu retires
2. Neha retires
3. Tina retires.
Ans: 
Given the old ratio among Madhu : Neha : Tina as 5 : 3 : 2
1. If Madhu retires, the new profit sharing Ratio between Neha and Tina will be
Neha : Tina = 3:2 and Gaining Ratio of Neha and Tina =3:2
2. If Neha retires the new profit-sharing Ratio between Madhu and Tina will be
Madhu : Tina = 5:2
Gaining Ratio of Madhu and Tina = 5:2
3. If Tina retires, the new profit-sharing ratio between Madhu and Neha will be:
Madhu : Neha = 5:3
Gaining ratio of Madhu and Neha = 5:3

Treatment of Goodwill

Goodwill belongs to the firm as a whole. On retirement or death, the outgoing partner is entitled to their share of goodwill. The continuing partners usually compensate the outgoing partner in the gaining ratio, because they obtain the benefit of the transferred profit share.

The accounting treatment depends on whether goodwill is already recorded:

• If goodwill is not recorded in the books: The firm must make entries to reflect the outgoing partner's share of goodwill. The usual practice is to debit the Goodwill account and credit the capital accounts of the gaining partners in their gaining ratio. The retiring partner's capital account is credited with their share of goodwill.
• If goodwill is already on the books: The firm adjusts partners' capital/current accounts directly in accordance with their respective shares and the agreed valuation.

The typical journal entry when goodwill is not recorded is:

Illustration: A, B and C share profits 3:2:1. B retires. Goodwill valued at Rs. 60,000. A and C continue with ratio 3:1. The adjustment of B's share of goodwill in the gaining ratio is shown below.

(B's share of goodwill adjusted to remaining partners' capital accounts in their gaining ratio)

Adjustment of Capital Accounts when Profit Sharing Ratio Changes

When there’s a change in the profit-sharing ratio among the remaining partners, sometimes a continuing partner might also give up a portion of their share in future profits. In this scenario:

• The capital account of the continuing partner who sacrifices will be credited, similar to the capital account of the retiring or deceased partner.
• The accounts of the other continuing partners will be debited based on their gain in the new profit-sharing ratio.

Example: Keshav, Nirmal and Pankaj are partners sharing profits and losses in the ratio of 4 : 3 : 2. Nirmal retires and goodwill is valued at Rs. 72,000. Keshav and Pankaj decide to share future profits in the ratio 5 : 3. Record necessary journal entries.
Ans: 

Working Notes:

Hidden Goodwill

• Hidden goodwill arises when the outgoing partner is paid a lump sum greater than the balance standing to their credit after all adjustments. The excess is treated as their share of goodwill.
• The excess amount is debited to the capital accounts of the continuing partners in their gaining ratio and credited to the retiring partner's capital account (or the executors in case of death).
• Example: P, Q and R share 3:2:1. R retires. Adjusted balance in R's capital = Rs. 60,000 but P and Q agree to pay Rs. 75,000. The excess Rs. 15,000 is hidden goodwill and will be debited to P and Q in the gaining ratio and credited to R.

Adjustment for Revaluation of Assets and Liabilities

At retirement or death, assets and liabilities should be brought to their current valuation. Any unrecorded assets or liabilities should be introduced to the books. A Revaluation Account (also called Profit and Loss on Revaluation) is prepared to show gains or losses arising from such revaluation. The net result is transferred to partners' capital accounts in the old profit-sharing ratio, including the outgoing partner for the period upto retirement/death.

Typical journal entries are passed for:

• Increase in value of an asset.
• Decrease in value of an asset.
• Increase in amount of a liability.
• Decrease in amount of a liability.
• Unrecorded asset discovered.
• Unrecorded liability discovered.
• Distribution of net profit or loss on revaluation among partners.

Illustration: Mitali, Indu and Geeta share 5:3:2. On 31 March 2017 their Balance Sheet is shown below.

Geeta retires on the above date. It was agreed that Machinery be valued at Rs.1,40,000; Patents at Rs. 40,000; and Buildings at Rs. 1,25,000. Record the necessary journal entries for the above adjustments and prepare the Revaluation Account.

Ans: 

Adjustment of Accumulated Profits and Losses

Accumulated profits (for example, general reserve) and accumulated losses are shared by partners in the old profit-sharing ratio. The retiring or deceased partner is entitled to his share of reserves and is liable for his share of losses. These amounts are transferred to partners' capital accounts.

Journal entries commonly used:

(i) For transfer of accumulated profits (reserves) to partners' capital accounts

(ii) For transfer of accumulated losses to partners' capital accounts

When a Partner Retires Mid-Year

• Often partners retire at the year end, but retirement may occur mid-year. The retiring partner is entitled to profit (or liable for loss) for the intervening period from the last balance sheet date to the date of retirement.
• Claims to be computed include the retiring partner's share of profit or loss for that intervening period, interest on capital (if allowed) for that period, and interest on drawings (if applicable).
• To compute the share of profit for the intervening period, the firm may use one of the following methods, depending on the agreement: proportion of annual profit, average profits, or a basis linked to sales.

Example in brief: Maira, Shabnam and Vipul share profits 5:4:1. Profit for year ending 31 March 2019 is Rs. 1,00,000. Vipul retires on 30 June 2019. New ratio of remaining partners becomes 1:1. Vipul's share for the period 1 April-30 June 2019 is computed as the firm's annual profit × (proportionate period) × (outgoing partner's share).

The following journal entry transfers Vipul's share of the intervening profit to his capital account:

Alternative bases that may be used (where specified in agreement):

• Average profits of past years (example shown with 3-year average).
• Proportion of sales for the intervening period compared to annual sales.

To bring the retiring partner's share of the intervening profit to the books, the Profit and Loss Suspense account may be used temporarily and later transferred to gaining partners' capital accounts in the gaining ratio.

Disposal of Amount Due to Retiring Partner

The retiring partner's account is settled according to the partnership deed. In the absence of a deed provision, Section 37 of the Indian Partnership Act, 1932 governs: the outgoing partner may elect to receive interest at 6% p.a. until payment, or a share of profits with capital (as if capital remained invested). Common settlement methods are immediate lump-sum payment, payment in instalments (with or without interest), or transfer to a loan account.

• If the firm can pay immediately, the retiring partner's capital account is debited and cash paid.
• If payment is deferred, the amount due is transferred to the retiring partner's Loan Account.
• If payment is part cash and part loan, appropriate entries combine both treatments.
• When the loan is repaid with instalments and interest, entries record interest and principal settlement over time.

Usual journal entries for different modes of settlement are:

1. When the retiring partner is paid cash in full

2. When the retiring partner's whole amount is treated as a loan

3. When retiring partner is partly paid in cash and remaining amount is a loan

4. When loan account is settled by instalments including principal and interest

Example: Amrinder, Mahinder and Joginder are partners. Mahinder retires. On his date of retirement Rs. 60,000 is due to him. Amrinder and Joginder promise to pay him in instalments every year at the end of the year with interest. Prepare Mahinder's Loan Account in the following cases: 1. Payment in four yearly instalments plus interest @ 12% p.a. on the unpaid balance. 2. Payment in three yearly instalments of Rs. 20,000 including interest @ 12% p.a. on the outstanding balance during the first three years and the balance including interest in the fourth year. 3. Payment in four equal yearly instalments including interest @ 12% p.a. on the unpaid balance. Ans: 

(b) When payment is made in three yearly instalments of Rs. 20,000 each including interest.

(c) When payment is made in four equal yearly instalments including interest @12% (Annually).

Adjustment of Partners' Capitals

After all revaluation, goodwill and reserve adjustments, partners may decide to re-fix capital balances to match the new profit-sharing ratio. The new total capital of the firm is usually the sum of the adjusted capital balances of the continuing partners (and any amount paid in to settle the outgoing partner). The total is then divided according to the new profit-sharing ratio to determine each partner's desired capital. Partners with excess capital withdraw cash; partners with deficient capital bring in cash.

Typical journal entries:

(i) For excess capital withdrawn by a partner:

(ii) For amount of capital to be brought in by a partner:

Consider these situations:

1. When the capital of the new firm is specified.

Example: Mohit, Neeraj and Sohan share profits 2:1:1. Neeraj retires. Mohit and Sohan decide that the capital of the new firm will be fixed at Rs. 1,20,000. The capital accounts of Mohit and Sohan show credit balances of Rs. 82,000 and Rs. 41,000 respectively after adjustments. Calculate cash to be paid off or to be brought in and pass necessary journal entries.

Ans: The New Profit Sharing Ratio between Mohit and Sohan = 2 : 1

2. When the total capital of the new firm is not specified.

Example: Asha, Deepa and Lata share profits 3:2:1. Deepa retires. After making all adjustments, Asha and Lata's capital accounts show Rs. 1,60,000 and Rs. 80,000 respectively. It is decided to adjust the capitals of Asha and Lata in their new profit sharing ratio. Calculate new capitals and record necessary journal entries.
Ans: 

a. Calculation of new capital of the existing partners
Balance in Asha’s Capital (after all adjustments) = 1,60,000
Balance in Lata’s Capital = 80,000
Total Capital of the New Firm = 2,40,000
Based on the new profit-sharing ratio of 3:1
Asha’s New Capital = Rs. 2,40,000  x 3/4 = 1,80,000
Lata’s New Capital = Rs. 2,40,000 x 1/4 = 60,000

b. Calculation of cash to be brought in or withdrawn by the continuing partners :

3. When the amount payable to retiring partner will be contributed by continuing partners so that their capitals become proportionate to the new profit sharing ratio.

Example: Lalit, Pankaj and Rahul share profits 4:3:3. After adjustments, their capital balances stand at Rs. 70,000; Rs. 60,000; and Rs. 50,000 respectively. Lalit retires. The amount payable to Lalit will be brought by Pankaj and Rahul so their capitals become proportionate to new ratio (1:1). Calculate amounts to be brought and record entries including payment to Lalit.
Ans: 

a. Total capital of the new firm = Pankaj's capital + Rahul's capital + Amount payable to Lalit = 60,000 + 50,000 + 70,000 = 1,80,000 b. New capitals: Pankaj's New Capital = 1,80,000 × 1/2 = 90,000 Rahul's New Capital = 1,80,000 × 1/2 = 90,000 c. Amounts to be brought in or withdrawn are calculated to adjust existing balances to the new target capitals.

Death of a Partner

• The accounting treatment on the death of a partner is similar to retirement; the deceased partner's claim is transferred to the executors and settled as per the partnership agreement.
• The key difference is timing: death can occur at any date in the year, so the deceased partner's share includes profit or loss, interest on capital, and interest on drawings for the intervening period from the last balance sheet date to the date of death.
• Calculating profit for the intervening period may be difficult; firms normally adopt an agreed method to estimate it.
• Methods to estimate the deceased partner's share for the intervening period:
  • Take last year's profit
  • Average profit of past few years
  • Proportion of sales for the intervening period compared to the year

Example: Bakul, Champak and Darshan share profits 5:4:1. Profit for year ending 31 March 2017 = Rs. 1,00,000. Champak died on 30 June 2017. Bakul and Darshan decide to share future profits equally. Champak's share for 1 April-30 June 2017 is computed as: Annual profit × (proportionate period) × Champak's share.

The journal entry to transfer Champak's share of the intervening profit to his capital (or executors) account is as follows:

Alternatively, Champak's share may be calculated using a three-year average or other agreed basis:

To record the deceased partner's share of the intervening profit in the books the following entry is commonly used:

Later, the Profit and Loss Suspense account is closed by transferring the amount to the gaining partners' capital accounts in their gaining ratio:

Alternatively, the combined entries for the above may be passed as:

Example: Anil, Bhanu and Chandu were partners in a firm sharing profits in the ratio of 5:3:2. On March 31, 2017, their Balance Sheet was as under:

Anil died on October 1, 2017. It was agreed between his executors and the remaining partners that :

(a) Goodwill to be valued atyear's purchase of the average profits of the previous four years which were :

• Year 2013-14 - Rs.13,000, Year 2014-15 - Rs. 12,000,
• Year 2015-16 - Rs.20,000, Year 2016-17 - Rs.15,000

(b) Patents be valued at Rs.8,000; Machinery at Rs.28,000; and Building at Rs.25,000. (c) Profit for the year 2017-18 be taken as having accrued at the same rate as that of the previous year. (d) Interest on capital be provided at 10% p.a. (e) Half of the amount due to Anil be paid immediately. Prepare Anil's Capital Account and Anil's Executor's Account as on October 1, 2017. Ans:

Working Notes:

1.

2. Goodwill = 2½ years' purchase × Average Profit

3. Profit from the date of the last balance sheet to the date of death
(April 1, 2017 to October 1, 2017) = 6 months
Profit for 6 months = Rs. 15,000 x (6/12) = Rs. 7,500
Anil’s share of profit = Rs. 7,500 x (5/10) = = Rs. 3,750 

4. Interest on Capital
(April 1, 2017 to October 1, 2017)
= Rs. 30,000 x (10/100) x (6/12)
= Rs.1,500