Reconstitution of
Partnership
Admission, Retirement and Death of a Partner
Financial Accounting Notes BCOM NEP 2023
Q.1. What
do you mean by “Reconstitution of a Partnership”? Under what situations it
takes place? Explain them.
Ans: Reconstitution of Partnership: A Partnership agreement is an agreement between two or more persons for carrying out various business activities. Reconstitution of a partnership refers to a situation when there is a change in the existing partnership agreement. In such a case, a new partnership agreement is formed to replace the old partnership agreement. It means the firm continues to exist and the only change will take place in existing partnership agreement. Thus, reconstitution of a partnership takes place in each of the following cases:
a) Change
on profit sharing ratio
b) Admission
of a partner (Refer below for explanation)
c) Retirement
of a partner
d) Death
of a partner
e) Insolvency
of a Partner
a) Change
in the profit-sharing ratio among the existing partners means the
reconstitution of firm without the admission or retirement or death of a
partner. In such case one or more partner acquires share of profit in the
business from another partner due to which share of profit of acquiring
partner’s increases and share of profit of sacrificing partners’ decreases.
Q.2. What
is revaluation and revaluation account? When and Why revaluation of Assets and
Liabilities are done in Partnership Business?
Ans:
Revaluation: Revaluation is a process of placing a
different valuation on an asset or liability from its book value. It is a
process of recoding of an asset or a liability at its current value.
Revaluation
Account: At the time of reconstitution of partnership,
it is necessary to revalue the assets and liabilities of the firm because the
book value of the assets and liabilities as shown in balance sheet may be
different from their market value. To record any decrease or increase in the
value of assets and liabilities, a separate nominal account is prepared which
is called revaluation account. The Revaluation account is credited if there is
an increase in the value of assets, decrease in the value of liabilities and
unrecorded assets. On the other hand, it is debited if there is any decrease in
the value of assets, an increase in the value of liabilities and unrecorded
liabilities. This account is a nominal account and is sometimes also called
Profit and Loss adjustment account. The profit or Loss arising due to
revaluation is divided among the old partners in their old ratio.
When?
Revaluation of Assets and Liabilities takes place in each of the following
cases:
a) Admission
of a partner
b) Retirement
of a partner
c) Death
of a partner
d) Change
on profit sharing ratio
Why/Objectives?
The actual value of the assets and
liabilities may be different from their book value as shown by the balance
sheet. When a new partner is admitted, he acquires ownership rights of the
assets and also becomes liable for the liabilities of the business. Therefore,
the new partner should get an assurance that these values are reasonable. The
new partner should not be given any benefit of appreciation in the value of
assets or reduction in the value of liabilities. Likewise, he should not be
burdened because of decrease in the value of assets and increase in the value
of liabilities. That’s why revaluation of assets and liabilities should be made
in the interest of the new partner as well as the old partners. Similarly, revaluation
of assets and liabilities are made at the time or retirement or death of a
partner.
Again, sometimes either intentionally or by
mistake, one or more assets and liabilities are not recorded in the books of
accounts. But while preparing revaluation account, these assets and liabilities
are to be recorded.
Q.3. What
is Memorandum Revaluation Account? Distinguish between Revaluation and
Memorandum revaluation account?
Ans: Memorandum Revaluation Account is
prepared when at the time of admission/retirement of a partner; the partnership
firm does not want to change the values of assets and liabilities in the
balance but wants to give its effect through partners' capital accounts.
Memorandum revaluation account is divided into two parts. First part is
prepared to record the increase or decrease in the value of assets and
liabilities and the second part is prepared to nullify the changes in the first
part. The balance of first part (Profit or loss) is transferred to the Capital
Accounts of Old Partners in their old profit-sharing ratio and the balance of
second part is transferred to all Partners Capital Accounts in their new profit
sharing ratio.
Difference
between Revaluation Account and Memorandum Revaluation account
|
Basis |
Revaluation Account |
Memorandum Revaluation Account |
|
1. Effect of Balance sheet |
After preparation of revaluation
account, assets and liabilities are shown in the balance sheet at the
revalued figures. |
There is no change in book value of
assets and liabilities after the preparation of memorandum revaluation
account. |
|
2. Parts |
It is not divided into two parts. It
is prepared to record the increase and decrease in the value of assets and
liabilities. |
It is divided into two parts. First
part is prepared to record the increase or decrease in the value of assets
and liabilities and the second part is prepared to nullify the changes in the
first part. |
|
3. Necessity |
Making of Revaluation account is
compulsory in case of reconstitution of partnership. |
Making of Memorandum Revaluation
account is not compulsory in case of reconstitution of partnership. |
|
4. Transfer of profit |
The balance of revaluation account
(profit or loss) is transferred to Old Partners Capital Accounts in their old
profit-sharing ratio. |
The balance of first part (Profit or
loss) is transferred to the Capital Accounts of Old Partners in their old
profit-sharing ratio and the balance of second part is transferred to all
Partners Capital Accounts in their new profit sharing ratio. |
|
5. Object |
It is prepared to record the effect
of revaluation of assets and liabilities when the assets and liabilities are
to be shown at their revalued amounts. |
It is prepared to record the effect
of revaluation of assets and liabilities when the assets and liabilities are
to be shown at their old values. |
Q.4. What
do you mean admission of a partner? Why a New Partner is admitted into
Partnership? Also mention its effect.
Ans: Admission of a partner: In order to
acquire additional capital and managerial skill, a new partner is admitted into
the firm with the consent of old existing partners. This process is called
admission of a partner. After admission of a partner, the firm is reconstituted
and existing agreements comes to an end and new agreement among all the
partners comes into effect. The new partner on joining becomes liable for the
liabilities of the firm and entitled to assets and profits of the firm.
Reasons
why a new partner is admitted?
Sometimes, it becomes difficult to run
the partnership business due to lack of sufficient capital or managerial help
or both. In this case a firm may decide to admit a new partner into the firm.
But according to Indian Partnership Act 1932, no partner can be admitted into
the firm without the consent of all the existing partners.
A person who is admitted as a partner
into the firm does not thereby becomes liable for any act of the firm done
before his admission. A partner is admitted for any one or more of the
following reasons:
a) In
order to acquire more capital for the business.
b) In
order to have more managerial skill, a competent and experienced person is
needed.
c) In
order to expand and boost up the business.
d) In
order to increase the goodwill by admitting a well-reputed person into the
business.
e) In
order to reduce the competition.
Effect of admission of a new partner: The effects of admission of a new partner are
the following:
a) The
admission of a partner constitutes the termination of existing partnership deed
and the commencement of a new one.
b) The new
partner is entitled to a share of future profits.
c) The new
partner has to contribute an agreed amount of capital to the business.
d) The new
partner acquires ownership rights of the assets and also becomes liable for the
liabilities of the business.
e)
Goodwill of the firm has to be valued and necessary adjustments are to be made
in partners account.
Also Read: FINANCIAL ACCOUNTING CHAPTERWISE NOTESUNIT 11. Preparation of Trial Balance and Preparation of Financial Statements UNIT 2Part A: Accounting for Partnership UNIT 3 UNIT 4 Some other Important Chapters
Q.5.
What is Sacrifice and Gaining Ratio? Distinguish between them.
Ans: Sacrificing Ratio: At
the time of admission of an incoming partner, existing partners have to
surrender some of their share in favour of the new partner. The ratio in which
they surrender their profits is known as sacrifice ratio. The purpose of
determining sacrificing ratio is to determine the amount of compensation that
partners should pay to the sacrificing partners for the share of profits
sacrificed by them.
Gaining
Ratio: Gaining Ratio is calculated at the time of
retirement or death of partner. It is the excess of new share over old share.
It is calculated as follows: Gaining Ratio = New share - Old share. Calculation
of gaining ratio is necessary to compensate the outgoing partners by payment of
goodwill in their gaining ratio.
Distinguish between sacrificing ratio and gaining ratio:
|
Basis |
Sacrifice
Ratio |
Gaining
Ratio |
|
Meaning |
Sacrificing
Ratio is a ratio in which the old partners have agreed to surrender their
share of profit in favour of new partner. |
Gaining
Ratio is ratios in which remaining partners’ gain the retiring partner’s
share. |
|
Objective |
The
main purpose to calculate the sacrificing ratio is to ascertain the compensation
to be paid by incoming partner to the sacrificing partner’s in the form of
goodwill. |
The
main purpose to calculate the gaining ratio is to find out the compensation
to be paid by the gaining partner’s to the retiring partner. |
|
When
to Calculate |
Sacrificing
Ratio is calculated at the time of admission of a new partner. |
Gaining
Ratio is calculated at the time of retirement or death of a partner. |
|
Method |
Sacrificing
Ratio = Old Ratio – New Ratio |
Gaining
Ratio = New Ratio – Old Ratio |
|
Effect |
It
reduces the profit sharing ratio of the existing partners. |
It
increases the profit sharing ratio of the remaining partners. |
Q.6.
Define Hidden Goodwill and Joint Life Policy.
Ans:
Hidden goodwill means that amount of goodwill which is not
known at the time of admission of a new partner but which is calculated on the
basis of total capital of the firm and profit sharing ratio. Hidden goodwill at
the time of admission of a partner is calculated as follow:
1. Calculate the total capital of the
firm on the basis of the capital brought in by new partner:
Total capital of the firm = New
Partner’s capital x reciprocal of new partner’s share
2. Find the total combined capital of
all the partners including new partner as below:
Capital Balance of Old partner’s +
Capital of new partner+ Accumulated profits-accumulated losses
3. Hidden goodwill will be = Total
capital of the firm – Combined capital of all the partners
A
Joint Life Policy is an assurance policy taken on the joint
lives of the partners. On the death of a partner, the firm becomes liable to
pay the executors of deceased partner his capital, interest on capital, his
share of profit, his share of reserves, goodwill etc. from the closing of the
previous year upto the date of death. The total amount thus becoming due to the
executors is usually significant and immediate payment of such heavy amount out
of firm’s resources is likely to affect firm’s finances very adversely. To
cover this liability, a joint life policy is taken.
Q.7. What
do you mean by retirement of partner? Mention the causes and effect of
retirement of partner. How the amount due to retiring Partner is calculated?
Ans: A partner may withdraw himself from the
partnership. This means that the old partnership agreement comes to an end and
new partnership among the remaining partners, comes into existence. The exit or
withdrawal of a partner is called retirement. As a result of retirement of a
partner his relations with the firm are severed. But a retiring partner remains
liable for all the acts of the firm upto the date of his retirement.
A partner may retire from the firm for
various reasons such as old age, bad health, strain relationship with other
partners, financial problems, residence shifting or any other reasons. A
partner may quit the firm with the consent of all the partners or when there is
an express agreement to this effect.
Effect
of retirement of a partner: The effects of retirement of a partner
are the following:
a) The retirement of partner will
terminate the existing partnership deed and a new partnership deed is
constituted.
b) The assets and liabilities are
revalued and proper adjustments are made in retiring partner’s account.
c) Goodwill of the firm has to be
valued and necessary adjustments are to be made in partners account.
d) An adjustment is to be made in
regard to undrawn profit or accumulated losses.
e) The claim of the retiring partner
is to be determined and settled.
Calculation
of amount due to the retiring partner: The
amount due to the retiring partner is paid according to the terms of
partnership agreement. Amount due to the retiring partner is determined by
preparing capital account of the retiring partner. Retiring partner’s capital
account is debited with:
(a) The credit balance of Capital
Account;
(b) His/her share in the Goodwill of
the firm;
(c) His/her share in the Revaluation
Profit:
(d) His/her share in General Reserve
and Accumulated Profit;
(e) His/her share of profit till the
date of his retirement.
(f) Interest on Capital, partner’s
salary and commission.
But, the following items are debited
in capital account to find amount due:
(a) His/her share in the Revaluation
loss.
(b) His/her Drawings and Interest on
Drawings up to the date of retirement.
(c) His/her share of any accumulated
losses.
(d) Loan taken from the firm.
Payment
of amount due to the retiring partners
The total amount so calculated is the
claim of the retiring partner. He/she is interested in receiving the amount at
the earliest. Total payment may be made immediately after his/her retirement.
However, the resources of the firm may not be adequate to make the payment to
the retiring partner in lump sum, then firm makes payment to retiring partner
in installments together with interest.
Q.8.
Explain the liability of retiring partner. What adjustments are necessary at
the time of admission, retirement or death of a partner?
Ans:
Liability of a retiring partner:
a) A retiring partner remains liable
for all the acts of the firm upto the date of his retirement. But if there is
an agreement between the continuing partner and third party, the retiring
partner may be discharged from his liability.
b) If a public notice is not given by
the retiring partner, then he will remain liable for all the acts of the firm
after the retirement.
Adjustments
required in case of admission, retirement and death of a partner:
a)
Determination of new profit-sharing ratio and sacrifice/gaining ratio.
b)
Accounting treatment of goodwill.
c)
Revaluation of assets and liabilities.
d)
Distribution of past reserves and accumulated profits or losses.
e)
Calculation of interest and profits upto the date of his retirement or death.
f)
Adjustment of capital of partners.
Q.9.
Explain the treatment of accumulated profits or losses at the time of
reconstitution of the firm.
Ans: For the purpose of expansion of the firm,
partnership firm may create reserves out of profits. These reserves appear in
the liabilities side of balance sheet. These undistributed profits belong to
the old partners. Therefore, these reserves are distributed amongst the old
partners in old ratio. Journal entry for distribution of reserves:
General Reserve A/c Dr
To Old Partners Capital Account
In the same manner, it is possible that firm
incurs losses and these losses appear in the assets side of the balance sheet.
These accumulated losses are also distributed amongst the partners at the time
of reconstitution of the partnership. Journal entry for distribution of
accumulated losses:
Old Partners Capital Account Dr
To Accumulated losses account
Q.10. How
the amount due to the executors of Deceased Partner is calculated? Explain the
provisions of Sec.37 of the Partnership Act regarding payment of the amount due
to the executors of the deceased partner?
Ans: The death may come at any time. On the
death of a partner, the legal heirs of the deceased partners are entitled to
get the amount due to the deceased partner as per the provisions of partnership
deed. On the death of a partner, the legal heirs or representatives are
entitled to get the following:
a) The
amount standing to the credit to the capital account of the deceased partner
b) Interest
on capital, if provided in the partnership deed upto the date of death:
c) Share
of goodwill of the firm;
d) Share
of undistributed profit or reserves;
e) Share
of profit on the revaluation of assets and liabilities;
f)
Share of profit upto the date of
death;
g) Share
of Joint Life Policy.
The following specimen of deceased partner’s
capital will help to find out the amount due to the deceased partner.
|
Particulars |
Amount |
Particulars |
Amount |
|
To Balance B/d (If there is a debit
balance) To Share in Revaluation loss To Accumulated losses To Drawings To Interest on Drawings To Profit and Loss Suspense A/c (Share in loss upto death) To Assets taken over To Executors Account (Balancing
figure) |
|
By Balance B/d (If there is a credit
balance) By Share in Revaluation Profit By Accumulated Profits and Reserves By Interest on Capital By Profit and Loss Suspense A/c (Share in profits upto death) By Liabilities taken over by legal
heirs |
|
Amount Due
to Deceased Partner (Sec. 37 of the partnership act)
The amount due to the deceased partner
is transferred to a loan account opened in the name of executor of the deceased
partner and payable by the existing partners. The agreement normally provides
for the interest payable on the loan and the conditions for the repayment of
such loan. In the absence of any agreement, it is provided in sec. 37 of
partnership act that the estate of deceased partner has the option either to
claim interest on the amount due @6% p.a. or to such a share of the subsequent
profits as may be attributable to the use of his share of the property of the
firm.
Q.11. How deceased partner’s share of profit
upto the date of death is calculated?
Ans: Calculation of profit upto the date of
death of a partner
If the death of a partner occurs
during the year, the representatives of the deceased partner are entitled to
his/her share of profits earned till the date of his/her death. Such profit is
ascertained by any of the following methods:
(i) Time Basis:
(ii) Turnover or Sales Basis
(i)
Time Basis: In this case, it is assumed that profit has
been earned uniformly throughout the year. Profit taken here is either Last year’s profit or Average profits of last few years. For
example:
The total profit of Last year is Rs.
2, 25,000 and a partner dies three months after the close of previous year, the
profit of three months is Rs. 31,250 i.e. 1, 25,000 × 3/12, if the deceased
partner took 2/10 share of profit, his/her share of profit till the date of
death is Rs. 6,250 i.e. Rs. 31,250 × 2/10.
Again, the profits of last three years
are Rs. 100000, Rs. 75000 and Rs. 125000 and partner dies three months after the
close of previous year, his share of profit upto date of death is calculated as
follows:
1. Average
profit of last three years = (100000+75000+125000)/3 = 100000
2. Profit
of last three years = 100000x3/12 = 25000
3. Deceased
partner’s share of profit = 25000 x 2/10 = 5000, if the deceased partner took
2/10 share of profit.
(ii) Turnover or Sales Basis: In this method, we have to take into
consideration the profit and the total sales of the last year. Thereafter the
profit upto the date of death is estimated on the basis of the following
formula:
(Sales upto date of death/Sales of
last year) x profit of previous year
Profit is assumed to be earned uniformly at
the same rate. For example:
A, B and C were partners in a firm
sharing profits in the ratio of 2:2:1. C dies on 31st July, 2007.
Sales during the previous year upto 31st march, 2007 were Rs. 6,
00,000 and profits were Rs. 150000. Sales for the current year upto 31st
July were Rs. 2,50,000. Calculate C’s share of profits upto the date of his
death and pass necessary journal entry.
Here, Profit upto date of death (upto
31st July, 2007) = (2,50,000/6,00,000) x 1,50,000 = 62,500 And C’s
Share of profit = 62,500x1/5 = 12,500.
Journal
entry for Crediting Deceased Partner’s share of profit upto date of death is:
Profit and Loss Suspense A/c Dr.
To Deceased Partner’s Capital A/c
Q.12. What
is Premium for Goodwill? Explain the treatment of goodwill at the time of
admission of a new partner.
Ans: Premium for Goodwill: When a new partner
is admitted into the firm, he is required to compensate in favour of partners
who sacrifices their shares in favour of new partner. The Compensation paid in
cash by the new partner to the sacrificing partners is called premium for
goodwill.
Treatment
of Goodwill at the time of admission of a new partner:
At the time of admission of a partner,
an adjustment is necessary in respect of goodwill. The goodwill can be treated
in the books of account I any of the following manners:
a)
When premium of goodwill is paid privately: A new
partner may premium to the old partners privately. In this case, no entry is
passed in the books of the firm as it is not a transaction of the firm.
b)
When capital and premium for goodwill is brought in cash/kind by new partner:
1)
Journal entries for cash/kind brought in
Cash account
Dr
Sundry asset account
Dr (If capital and premium brought in kind)
To New Partner’s Capital account (New
partner’s share of capital)
To Premium for goodwill account (New
partner’s share of goodwill)
2) For sharing of premium of goodwill:
Premium
for goodwill account Dr
To
Sacrificing partner’s capital account
3) If premium for goodwill is
withdrawn either fully or partly by sacrificing partners:
Sacrificing
partner’s capital account Dr
To
Cash/Bank account
c) When premium for goodwill is not brought in by new partner:
New
partner’s capital account
Dr
To
Sacrificing partner’s capital account
d) If goodwill already appears in balance sheet of the old firm,
then it is to be written off in every case
Old
partner’s capital account Dr
To
Goodwill account
Treatment of goodwill in case of retirement and death of a
partner:
At the time of retirement or death of
a partner, goodwill is to be adjusted amongst the partners on the basis of
sacrifice or gain. First of goodwill of the firm is valued on the retirement or
death of a partner and the retiring or deceased partner’s share in new goodwill
of the firm is to be contributed by the remaining partners in gaining ratio.
Journal entry for recording retiring
or deceased partner’s share of goodwill
Retiring partner or deceased partner’s
capital account Dr
To Gaining or remaining partners’
capital account
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