Reconstitution of a Partnership Firm

2.1 Core concepts

Sum due to retiring / deceased partner (§3.1, p. 107). The outgoing partner is entitled to: (i) credit balance of his Capital A/c, (ii) credit balance of his Current A/c, (iii) his share of goodwill, (iv) his share of accumulated profits / reserves, (v) his share of gain on revaluation, (vi) his share of profit up to the date of retirement / death, (vii) interest on capital and (viii) salary / commission due to him. Deductions from his share include the debit balance of Current A/c, share of goodwill to be written off, share of accumulated losses, share of revaluation loss, drawings during the period, and interest on drawings.

New profit-sharing ratio (§3.2, p. 108-109). The ratio in which the remaining partners share future profits after the outgoing partner leaves. New Share = Old Share + Share Acquired from the outgoing partner. In the absence of information, the remaining partners are assumed to acquire the outgoing partner's share in their old ratio, so the new ratio equals their old ratio.

Gaining Ratio (§3.3, p. 110-112). The ratio in which continuing partners acquire the share from the retiring / deceased partner: Gaining Share = New Share − Old Share. It must be calculated only when the new profit-sharing ratio is specified; otherwise it equals the old ratio or the specified acquisition ratio.

Goodwill treatment (§3.4, p. 113-114). The retiring / deceased partner is entitled to his share of goodwill because goodwill was built by the efforts of all partners. Gaining partners compensate him in their gaining ratio: Dr Gaining Partners' Capital A/cs (individually), Cr Retiring / Deceased Partner's Capital A/c. If goodwill already appears in the books, it is first written off by debiting all partners' capital accounts (including the retiring) in their old profit-sharing ratio, and then the retiring partner is credited with his share of the current value of goodwill via gaining partners.

Hidden goodwill (§3.4.2, p. 118-119). When a lump sum is agreed to be paid in full settlement of the retiring / deceased partner, the excess of that lump sum over his adjusted capital balance is treated as his share of goodwill and adjusted via gaining partners.

Revaluation of assets and liabilities (§3.5, p. 120-121). A Revaluation Account is prepared; increase in assets and decrease in liabilities are credited to it; decrease in assets, increase in liabilities and unrecorded liabilities are debited; unrecorded assets are credited. The net gain / loss is transferred to all partners' capital accounts (including the retiring) in the old profit-sharing ratio, because the underlying changes relate to the period before reconstitution.

Accumulated profits and losses (§3.6, p. 122). General Reserve and the credit balance of P&L belong to all partners and are distributed to all partners' capital accounts in the old profit-sharing ratio. Accumulated losses are similarly distributed in the old ratio by debiting the partners.

Retirement in middle of the year (§3.6, p. 123-125). Share of profit for the intervening period from the last balance sheet to the date of retirement / death is computed on (a) last year's profit basis, (b) average profit basis or (c) sales basis. Journal entry: Dr Profit & Loss Suspense A/c, Cr Retiring / Deceased Partner's Capital A/c.

Disposal of amount due (§3.7, p. 125-126). Settled per partnership deed: (a) lump sum in cash, (b) full amount transferred to a Retiring Partner's Loan A/c, or (c) part cash + part loan. Loan A/c is shown on the liabilities side until the final instalment. Interest on loan is debited to Interest A/c and credited to Retiring Partner's Loan A/c. Section 37 default — in the absence of any agreement, the outgoing partner may opt for interest @ 6% p.a. on the unpaid balance OR a proportionate share of profit earned with his money.

Adjustment of Partners' Capitals (§3.8, p. 134-138). Continuing partners may decide to keep their capitals in the new profit-sharing ratio. Total capital may be (i) specified by the partners, (ii) computed as the sum of their existing capital balances after all adjustments, or (iii) equal to the existing capitals of continuing partners plus the amount payable to the retiring partner. Surplus is paid off through cash / bank; shortage is brought in.

Death of a partner (§3.9, p. 140-141). Accounting is similar to retirement, but (a) the amount payable is transferred to the deceased partner's Executor's Account, and (b) death can occur mid-year, so the claim must include share of profit, interest on capital, interest on drawings and other dues from the last balance sheet date to the date of death. Three methods to compute share of profit till date of death: (i) last year's profit × time proportion × share, (ii) average of past few years' profit × time proportion × share, (iii) Sales basis — profit × (sales during period ÷ sales of last year) × share.

2.2 Definitions to memorise

2.3 Diagrams / processes to remember

New Ratio Computation (NCERT §3.2, p. 109). Naveen-Suresh-Tarun 5:3:2 → 7:3 after Suresh's retirement. Show acquired share added to old share to derive the new ratio.

Mahinder's Loan Account variants (NCERT p. 126-128). Three variants: (a) four yearly instalments of principal + interest @12%, (b) three yearly instalments of ₹20,000 including interest, (c) four equal annual instalments including interest of ₹19,754. Memorise the structure of each.

Anil's Capital and Executor's Account (NCERT Illus. 18, p. 143). ₹57,000 due, half paid immediately, balance carried forward; demonstrates the executor's account format.

Revaluation Account Format (NCERT Illus. 10, p. 121-122). Losses on Dr side, gains on Cr side, balancing profit / loss transferred to all partners' capital in old ratio.

Three Modes of Capital Adjustment (NCERT §3.8, p. 134-137). Specified total capital (Illus. 14), sum-of-balances method (Illus. 15), existing-capital-plus-payable method (Illus. 16).

Process — Computing the Gaining Ratio. (i) Identify each continuing partner's new share (given or derived). (ii) Gain = New − Old. (iii) Express the positive gains in a ratio. (iv) If any continuing partner has a negative gain (i.e., sacrifice), treat him as a sacrificing partner — see Illus. 8.

Process — Goodwill on Retirement / Death. (i) Write off existing goodwill in old ratio across all partners. (ii) Compute the retiring partner's share of (current) goodwill. (iii) Dr gaining partners in gaining ratio; Cr retiring partner. (iv) For hidden goodwill, compare agreed settlement with adjusted capital balance and treat the difference as share of goodwill.

Process — Share of profit till date of retirement / death. (i) Identify the basis stated in the deed — last year, average of past years, or sales. (ii) Apply the chosen formula. (iii) Pass Dr P&L Suspense A/c, Cr Retiring / Deceased Partner's Capital A/c. (iv) The Suspense A/c is closed against the next year's P&L.

Process — Final Settlement. Once all adjustments are passed, compute the closing balance of the retiring / deceased partner's capital. If paid immediately → Dr Capital, Cr Cash/Bank. If unpaid → Dr Capital, Cr Loan A/c (retirement) or Executor's A/c (death). Interest @ 6% p.a. accrues on unpaid balance under Section 37 (if no agreement).

2.4 Common confusions / NTA trap points

1. Reserves and revaluation profit are distributed in OLD ratio. Goodwill is adjusted in GAINING ratio (only gainers debited, retiring credited). Students often interchange these (NCERT §3.4-§3.6, p. 113-122).
2. Sacrificing vs Gaining Ratio. Gaining = New − Old; Sacrificing = Old − New. NTA loves swapped-formula distractors (NCERT §3.3, p. 110 vs leac102 §2.4).
3. Existing goodwill write-off step is mandatory. First write off in old ratio across all partners (including retiring) — only then credit the retiring partner with current goodwill share (NCERT §3.4 Illus. 9, p. 117).
4. Hidden goodwill comparison. Compare lump sum with adjusted capital balance after all adjustments (reserves, revaluation, profit till date); don't compare with the unadjusted capital (NCERT §3.4.2, p. 118).
5. Section 37 default rate. 6% p.a. — not 12% or 10%. NTA inserts 8%, 10%, 12% as distractors (NCERT §3.7, p. 125).
6. Sales-basis formula. Profit of last year × (Sales of intervening period ÷ Sales of last year) × share — not a direct percentage of sales of intervening period (NCERT §3.9, p. 141).
7. Mid-year death requires more adjustments. Must include interest on capital, interest on drawings and salary up to the date of death — easy to miss (NCERT §3.9, p. 141).
8. Continuing partner can also sacrifice. When the new ratio re-allocates among continuing partners, a continuing partner may sacrifice and be entitled to compensation from gainers — see Illus. 8 (NCERT p. 116).
9. Executor's A/c (death) ≠ Loan A/c (retirement). The destination of unpaid balance differs (NCERT §3.7 vs §3.9).
10. Profit & Loss Suspense A/c. Used only for share of profit till date when actual profit cannot be computed — distinct from a regular P&L Adjustment A/c (NCERT §3.9, p. 142).
11. Old ratio for distribution of reserves. Even when only one partner retires, all partners (including retiring) share the reserves in old ratio (NCERT §3.6, p. 122).
12. Adjusted capital balance for hidden goodwill. Must include positive items (reserves, revaluation profit, profit till date) and negative items (drawings, interest on drawings, accumulated losses) (NCERT §3.4.2, p. 118).

2.5 Journal entry templates

(a) Existing goodwill written off in old ratio (NCERT §3.4 Illus. 9, p. 117)

(b) Retiring partner credited with share of current goodwill (NCERT §3.4.1, p. 114)

(c) Distribution of General Reserve in old ratio (NCERT §3.6, p. 122)

(d) Revaluation profit transferred to all partners (NCERT §3.5, p. 121)

(e) Share of profit till date of retirement via Suspense A/c (NCERT §3.6, p. 125)

(f) Transfer of final balance to Retiring Partner's Loan A/c (NCERT §3.7, p. 125)

(g) Interest @ 6% p.a. on retiring partner's loan — Section 37 default (NCERT §3.7, p. 125)

(h) Transfer of final balance to deceased partner's Executor's A/c (NCERT §3.9, p. 142)