Reconstitution of a Partnership Firm

2.1 Core concepts

Reconstitution (§2.1, p. 48-49). Any change in the existing partnership agreement amounts to reconstitution — the old agreement ends and a new agreement comes into being, even though the firm itself continues. NCERT names four modes: admission, change in profit-sharing ratio, retirement, and death of a partner. This chapter handles the first mode.

Admission of a new partner (§2.2, p. 49). Under the Partnership Act 1932, a new partner can be admitted only with the consent of all existing partners (unless the deed says otherwise). The incoming partner acquires (i) the right to share assets and (ii) the right to share profits — for which he brings (a) capital and (b) in an established profit-earning firm, a premium called goodwill. Admission triggers a six-point checklist of adjustments (§2.2, p. 50): (1) new profit-sharing ratio, (2) sacrificing ratio, (3) valuation and treatment of goodwill, (4) revaluation of assets and reassessment of liabilities, (5) distribution of accumulated profits and reserves, (6) adjustment of partners' capitals.

New profit-sharing ratio (§2.3, p. 50-52). The new partner takes his share from the old partners. If the mode of acquisition is silent, it is assumed he gets the share from them in their old ratio. Each old partner's new share = old share − share surrendered to incoming partner. NCERT's Illustration 1 (p. 50) develops this: A and B at 3:2, admit C for 1/6 — new ratio 3:2:1.

Sacrificing ratio (§2.4, p. 52-55). The ratio in which old partners forgo their profit shares in favour of the new partner: Sacrifice = Old Share − New Share. The premium for goodwill brought by the new partner is shared by old partners in this ratio. If the new ratio is silent, sacrifice = old ratio; if the new ratio is specified, sacrifice is recomputed and may differ from the old ratio. NCERT Illustration 6 (p. 53) shows that Rohit's sacrifice (3/56) is less than Mohit's (5/56) even though Rohit had the larger original share.

Goodwill — meaning (§2.5.1, p. 55-56). Goodwill is the monetary value of a firm's good name, reputation and business connections that enables it to earn super profits over and above the normal rate of return. It is an intangible asset and exists only when the firm earns super profits.

Factors affecting goodwill (§2.5.2, p. 56). Nature of business, location, efficiency of management, market situation (monopoly/limited competition), and special advantages such as licences, patents, trademarks and long-term contracts.

Need for valuation (§2.5.3, p. 56). Arises on change in profit-sharing ratio, admission, retirement, death, dissolution involving sale as a going concern, and amalgamation of firms.

Goodwill — Average Profits Method (§2.5.4.1, p. 57-59). Goodwill = Average Profits × Number of years' purchase. Weighted average (with weights 1, 2, 3, 4, 5 etc.) is used only when an increasing/decreasing trend exists and weights are specified.

Goodwill — Super Profits Method (§2.5.4.2, p. 60-62). Normal Profit = Firm's Capital × Normal Rate of Return ÷ 100; Super Profit = Average Profit − Normal Profit; Goodwill = Super Profit × Number of years' purchase. The firm's capital excludes goodwill and fictitious assets. NCERT Illustration 13 (p. 61-62) goes further — Normal Profit also includes notional partners' salary at market rates.

Goodwill — Capitalisation Method (§2.5.4.3, p. 62-64). Two sub-methods, both giving the same figure. (a) Capitalisation of average profits: Goodwill = (Average Profit × 100 ÷ Normal Rate) − Net Assets, where Net Assets = Total Assets (excluding goodwill) − Outside Liabilities. (b) Capitalisation of super profits: Goodwill = Super Profit × 100 ÷ Normal Rate.

Treatment of goodwill — premium in cash (§2.5.5.1, p. 64-69). Premium brought by the new partner is shared by old partners in sacrificing ratio. If goodwill already exists in the books, it is first written off in the old ratio among the old partners.

When goodwill is not brought (fully/partly). The new partner's Current A/c (not Capital A/c) is debited for his share of goodwill; sacrificing partners' Capital A/cs are credited in sacrificing ratio. If goodwill already appears in books, it is first written off in old ratio.

AS-26 (p. 72-73). Internally generated / self-generated goodwill cannot be recognised as an asset; only purchased goodwill may be shown and written off over a period not exceeding 10 years. Therefore goodwill appearing in the balance sheet at the time of reconstitution is written off because it is presumed self-generated.

Hidden goodwill (§2.5.5.2, p. 74-76). When goodwill of the firm is not stated, it is inferred from the capital arrangement: Implied total capital = New Partner's Capital × (1 / his share); Goodwill of the firm = Implied Total Capital − Sum of all partners' capitals after admission. The new partner's share of this goodwill is debited to his Current A/c if not brought in cash.

Accumulated profits and losses (§2.6, p. 76-77). General Reserve / credit balance of P&L are transferred to old partners' Capital A/cs in old ratio — Dr Reserve/P&L, Cr old capitals. Accumulated losses or debit balance of P&L are transferred the other way — Dr old capitals, Cr P&L.

Revaluation of assets and reassessment of liabilities (§2.7, p. 77-82). A Revaluation Account is prepared. Increase in asset and decrease in liability are credited (gain); decrease in asset and increase in liability are debited (loss). Unrecorded assets are credited; unrecorded liabilities are debited. The net gain/loss is transferred to old partners' Capital A/cs in old profit-sharing ratio — because the underlying changes relate to the period before admission.

Adjustment of capitals (§2.8, p. 83-93). Old partners' capitals may be adjusted to be proportionate to the new profit-sharing ratio. Using the new partner's capital as the base, total capital of firm = new partner's capital × reciprocal of his share. Each old partner's new capital = total × his new share. The partner with deficiency brings cash (or his Current A/c is debited); the partner with surplus withdraws cash (or his Current A/c is credited).

Change in profit-sharing ratio among existing partners (§2.9, p. 93-96). Without admission/retirement, the same six adjustments are needed. Gaining partners' Capital A/cs are debited and sacrificing partners' Capital A/cs are credited, in the ratio of gain/sacrifice multiplied by the firm's goodwill.

2.2 Definitions to memorise

2.3 Diagrams / processes to remember

Six-step admission checklist box (NCERT §2.2, p. 50). New ratio → sacrificing ratio → goodwill valuation and treatment → revaluation → reserves → capital adjustment. Memorise the order — CUET asks "which is the first step on admission" frequently.

Revaluation Account Format (NCERT §2.7, p. 77-78). Dr side: fall in assets, rise in liabilities, unrecorded liabilities, profit transferred to old capitals (if credit balance). Cr side: rise in assets, fall in liabilities, unrecorded assets, loss transferred to old capitals (if debit balance).

Partners' Capital Accounts Layout (NCERT Illus. 23, p. 80-81). Each old partner's capital A/c shows transfer of goodwill, revaluation profit / loss, reserve transfer, premium received, and balance c/d after admission. The new partner's capital A/c shows capital introduced and goodwill premium (if not brought in cash, his Current A/c is debited).

AS-26 Callout Box (NCERT p. 72-73). Only purchased goodwill may be recognised; self-generated goodwill cannot. Existing goodwill in books on reconstitution is written off in old ratio.

Process — Computing new ratio when surrender is in old ratio. (i) Compute the new partner's share. (ii) Remaining share = 1 − new partner's share. (iii) Multiply each old partner's old share by the remaining share. (iv) Express the result in lowest integers.

Process — Computing sacrificing ratio. (i) Identify each old partner's new share (given or derived). (ii) Sacrifice = Old − New for each. (iii) Divide each sacrifice by total sacrifice to express the ratio.

Process — Goodwill by Super Profits Method. (i) Compute average profit over the agreed years. (ii) Compute normal profit = Firm's Capital × Normal Rate / 100 (add notional partners' salary if specified). (iii) Super profit = Average − Normal. (iv) Goodwill = Super profit × years' purchase.

Process — Hidden Goodwill. (i) Compute implied total capital of new firm = New partner's capital × (1 / his share). (ii) Subtract sum of all partners' capitals after admission (including new partner's). (iii) Result is goodwill of firm. (iv) New partner's share = his profit-share × goodwill.

Process — Treatment of existing goodwill on admission. (i) Write off existing goodwill in old ratio: Dr each old partner's Capital A/c, Cr Goodwill A/c. (ii) Then proceed with sacrificing-ratio treatment for the new goodwill brought / not brought.

2.4 Common confusions / NTA trap points

1. Sacrificing ratio vs old ratio. Equal only when the mode of acquisition is silent; if a new ratio is given, sacrifice = old − new and must be recomputed (NCERT §2.4, p. 52).
2. Gain ratio = Sacrifice ratio? No — when existing partners change ratio inter se, some gain (debit their capital) and others sacrifice (credit their capital) (NCERT §2.9, p. 93).
3. Writing off existing goodwill in NEW ratio. Wrong — AS-26 requires it to be written off in the old profit-sharing ratio (NCERT box, p. 72-73).
4. Revaluation gain/loss transferred in NEW ratio. Wrong — it belongs to old partners and is shared in old ratio (NCERT §2.7, p. 81).
5. Including goodwill / fictitious assets in firm's capital for super-profits method. Both are excluded (NCERT §2.5.4.2, p. 60).
6. When goodwill is not brought. Use new partner's Current A/c (not Capital A/c) — debited against sacrificing partners' capitals (NCERT §2.5.5.1, Illus. 19, p. 70).
7. Hidden goodwill formula. Implied total capital = New capital × reciprocal of new share; subtract sum of all partners' capitals (NCERT §2.5.5.2, p. 74-76).
8. Distribution of reserves in NEW ratio. Wrong — reserves belong to old partners in old ratio (NCERT §2.6, p. 76).
9. Debit balance of P&L is a loss. Distributed to old partners in old ratio (Dr their capitals) (NCERT §2.6, Illus. 22).
10. Goodwill brought in kind. Debit the asset, credit Premium for Goodwill A/c — then distribute as usual (NCERT §2.5.5.1, p. 67).
11. Notional salary in normal profit. Some illustrations (Illus. 13, p. 61) add a notional partners' salary at market rates to normal profit — easy to miss.
12. Adjustment of capitals — which figure is base. Use the new partner's capital as the base for computing total firm capital — not the average of old capitals (NCERT §2.8, Illus. 25, p. 83).

2.5 Journal entry templates

(a) Premium for goodwill brought in cash, distributed in sacrificing ratio (NCERT §2.5.5.1, p. 65)

(b) Goodwill not brought — debit to new partner's Current A/c (NCERT §2.5.5.1, Illus. 19, p. 70)

(c) Writing off existing goodwill in old ratio (NCERT §2.5.5.1, p. 68; AS-26 box)

(d) Transfer of General Reserve to old partners (NCERT §2.6, Illus. 22, p. 77)

(e) Transfer of debit balance of P&L (accumulated loss) (NCERT §2.6, p. 77)

(f) Increase in value of an asset on revaluation (NCERT §2.7, p. 78)

(g) Bringing in an unrecorded liability (NCERT §2.7, p. 78)

(h) Distribution of revaluation profit / loss to old partners (NCERT §2.7, p. 81)