Reconstitution of a Partnership Firm

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XII (Accountancy Part I), Chapter 3.

What does a partner take with him when he leaves?

Nisha, Omar and Pooja own a bakery. Nisha, who put in the most capital and built the first customers, decides to retire. She does not just collect her capital back. The bakery now has a loyal customer base, a reserve built from past profits and an oven worth more than its book value. All of that is partly hers, and Omar and Pooja are about to take over her share of future profits.

This chapter turns that story into arithmetic. When a partner retires or dies, the old deed ends and a new one begins with the continuing partners, while the firm itself carries on. The accounting for retirement and for death is the same, with two differences: on death the amount due goes to the Executor's Account, and death can happen mid year, so profit up to the date of death must be found. The central question is always the same: how much is the outgoing partner owed, and how is it paid?

What the outgoing partner is owed

Everything the partner built is credited to him, and everything he owes is deducted.

New ratio and gaining ratio

The remaining partners take over the outgoing partner's share. How much each one gains is the gaining share.

$$\text{Gaining share} = \text{New share} - \text{Old share}$$

If nothing is said, the continuing partners are taken to share the retiring partner's share in their old ratio, so their new ratio is simply their old ratio. If a new ratio is stated, the gain must be worked out for each partner.

Worked example: three ways to find the gaining ratio.

Common wrong step. Using the new ratio as the gaining ratio. In (c) the new ratio is 3:2, but the gain is split 1:1. Always subtract old from new, partner by partner, and check that the gains add up to the outgoing partner's old share.

A continuing partner can sacrifice. Sometimes the new ratio gives one continuing partner less than before. X, Y and Z share 2:2:1. Z retires and X and Y decide to share 1:3.

Y's gain of $\tfrac{7}{20}$ covers Z's $\tfrac{4}{20}$ plus X's $\tfrac{3}{20}$. So Y must compensate both Z and X, which is why gain and sacrifice must be worked partner by partner.

Pause and predict: In the table above, goodwill of the firm is ₹2,00,000. How much does Y pay in total, and who receives it?

Check your answer: Y pays $\tfrac{7}{20} \times 2{,}00{,}000 = 70{,}000$. Z receives $\tfrac{4}{20}$, which is ₹40,000, and X receives $\tfrac{3}{20}$, which is ₹30,000. The two receipts add up to Y's payment.

Goodwill: why the gainers pay

Goodwill was built by all the partners, including the one leaving. So the retiring partner must be paid his share of it. Who pays? Those who gain from his exit, because they now enjoy his share of future profits. Hence goodwill is adjusted in the gaining ratio: the gainers' Capital A/cs are debited, and the retiring partner's is credited.

Where there is already goodwill in the books, write it off first. It belongs to all partners (including the retiring one), so it is debited to all their capitals in the old ratio. Then credit the retiring partner with his share of the current value, from the gainers.

Worked example: goodwill with old goodwill in the books. A, B and C share 3:2:1. B retires, and A and C continue in the ratio 2:1. The books show goodwill of ₹24,000. The firm's goodwill is now valued at ₹60,000.

Both entries balance, at ₹24,000 and ₹20,000. Common wrong step. Debiting the old goodwill only to the continuing partners. B helped build that asset, so B bears his share of the write off.

Hidden goodwill: a lump sum that says more than the books

Sometimes the partners agree to pay a lump sum in full settlement. If that sum is more than the retiring partner's capital after all adjustments, the extra must be his share of goodwill.

$$\text{Retiring partner's share of goodwill} = \text{Lump sum agreed} - \text{Adjusted capital balance}$$

Worked example. P, Q and R share 3:2:1. R retires and is to be paid ₹75,000 in full settlement. After reserves, revaluation and every other adjustment, R's capital is ₹60,000. P and Q share profits in their old ratio.

Entry: P's Capital A/c Dr ₹9,000, Q's Capital A/c Dr ₹6,000, To R's Capital A/c ₹15,000. R's capital then stands at ₹75,000 and is paid out. Common wrong step. Comparing the lump sum with R's capital before the reserve and revaluation have been added. The comparison is always with the adjusted capital.

Revaluation and reserves: the same, but now everyone shares

The logic is the same as on admission: assets and liabilities are revalued, and the Revaluation Account is closed to the partners. The difference is who shares. Revaluation and reserves belong to the period when the retiring partner was still a partner, so all partners, including the one leaving, share them in the old ratio.

Direction of revaluation entries is unchanged: assets up and liabilities down are gains (credit), assets down, liabilities up and unrecorded liabilities are losses (debit), and an unrecorded asset is a gain (credit).

Worked example: a complete retirement. A, B and C share 3:2:1. The balance sheet on 1 April is below. B retires. Land is revalued up by ₹60,000, stock is written down by ₹20,000 and machinery by ₹10,000. Goodwill is valued at ₹1,20,000 and has not been recorded in the books. A and C will continue in the ratio 2:1. B is paid ₹70,000 at once, and the balance is transferred to B's Loan Account. Prepare the Revaluation Account, the Capital Accounts and the new Balance Sheet.

Revaluation Account. Gain = 60,000 − 20,000 − 10,000 = ₹30,000, shared 3:2:1.

Capital Accounts. Credits are shown as positive amounts and debits as negative amounts.

B's share of goodwill is $\tfrac{2}{6} \times 1{,}20{,}000 = 40{,}000$, paid by A and C in their gaining ratio 1:1 (A gains $\tfrac{2}{3} - \tfrac{1}{2} = \tfrac{1}{6}$ and C gains $\tfrac{1}{3} - \tfrac{1}{6} = \tfrac{1}{6}$), which is 20,000 each. Final amount due to B is 2,00,000 + 20,000 + 10,000 + 40,000 = ₹2,70,000.

Common wrong steps. First, leaving B out of the reserve and revaluation share (B would lose ₹30,000 that belongs to him). Second, sharing B's goodwill between A and C in their old ratio 3:1 or their new ratio 2:1. Their gaining ratio, 1:1, is the only correct one for goodwill.

Beyond the textbook. For the exam: a retiring partner is paid out, and the amount is transferred to a loan account if not paid at once. In reality: a retired partner remains liable to the firm's creditors for debts incurred while he was a partner, unless the creditors agree to release him. He also remains liable for later dealings of the firm until public notice of his retirement is given. Why it matters: this is why a real retirement deed is accompanied by notices, while the accounting here deals only with what the partners owe each other.

Profit up to the date of leaving

Suppose Nisha leaves on 30 June, three months into the year. She helped earn profit for those three months, but the books will not be closed until 31 March. So her share of profit for the intervening period is estimated, credited to her, and debited to a Profit and Loss Suspense Account. That account is cleared when the real profit is known at the end of the year. The deed decides the basis.

$$\text{Share of profit} = \text{Profit of the period} \times \text{Partner's old share}$$

Worked example: three bases, one answer each. Champak holds a $\tfrac{4}{10}$ share and dies on 30 June, after three months of the year. Last year's profit was ₹1,20,000, and the profits of the past four years were ₹80,000, ₹1,00,000, ₹1,00,000 and ₹1,20,000. Sales last year were ₹12,00,000 and sales from 1 April to 30 June were ₹4,00,000.

On the last year's basis the entry is Profit and Loss Suspense A/c Dr ₹12,000, To Champak's Capital A/c ₹12,000. Common wrong step. On the sales basis, taking the profit as a percentage of the period's sales alone, without scaling by last year's profit and sales.

Death: the Executor's Account

When a partner dies, the sum due goes to his legal heirs, not to him. So instead of a Loan A/c in his name, it is credited to his Executor's Account. The claim includes everything on the table of dues above, plus the profit, interest on capital and salary up to the date of death, less drawings up to that date.

Worked example: the amount due on death. Champak's capital is ₹2,00,000. Interest on capital at 6% p.a. is allowed for the three months, his share of profit is ₹12,000 (last year's basis), his share of goodwill is ₹20,000 and his drawings till death are ₹15,000. ₹70,000 is paid to the executor immediately.

The balance of ₹1,50,000 stays as a liability in the Executor's Account until it is paid.

Beyond the textbook. For the exam: death of a partner is a reconstitution, and the firm continues. In reality: unless the deed says otherwise, the Partnership Act treats the death of a partner as dissolving the firm. The firm carries on in these questions because the deed contains a continuation clause. Why it matters: the deed, not the textbook default, decides what happens on death. In every question here the firm continues, so apply the settlement rules above.

How the balance is paid

If the partners do not agree on terms, the Partnership Act gives the outgoing partner a choice. He may claim interest at 6% per annum on the unpaid balance, or the share of profit earned from the use of his money. The rate is 6%, not 10% or 12%.

Worked example: a loan repaid in four yearly instalments. B's loan of ₹2,00,000 carries interest at 6% p.a. on the balance outstanding at the start of each year. It is repaid in four equal principal instalments of ₹50,000, each paid at the end of the year along with that year's interest.

The year 1 entries are Interest A/c Dr ₹12,000, To B's Loan A/c ₹12,000, then B's Loan A/c Dr ₹62,000, To Bank A/c ₹62,000. Both entries balance. Common wrong step. Charging interest every year on the original ₹2,00,000. Interest runs on the balance still outstanding.

Pause and predict: A partner retires and no deed or agreement says anything about interest. The balance is left in the firm. What may he claim?

Check your answer: Either 6% interest on the unpaid balance, or a share of the profit that the firm has earned using his money, whichever he chooses.

Adjusting the capitals of the continuing partners

The continuing partners may want their capitals to match the new ratio. In the retirement above, A and C are left with ₹3,25,000 and ₹95,000 and share 2:1. There are three common ways to fix the total.

In each case, a partner with a shortage brings cash and a partner with a surplus withdraws it. The third row also shows why the method is used: the fresh capital pays the outgoing partner without draining the firm's cash.

Exam traps

Formula and format sheet

60-second revision

Where this chapter connects

The mirror image of this chapter is Admission of a Partner: there the newcomer pays the sacrificing partners, and here the gainers pay the leaver. The goodwill, revaluation and capital methods are the same tools. When the whole firm winds up instead of changing hands, Dissolution of a Partnership Firm takes over, and the Realisation Account replaces the Revaluation Account. The ratios themselves come from Accounting for Partnership: Basic Concepts.