ADMISSION OF A PARTNER

RECONSTITUTION OF A PARTNERSHIP FIRM - ADMISSION OF A PARTNER Partnership is an agreement between two or more persons for sharing the profits of a business carried on by all or any of them acting for all. Any change in the existing agreement leads to reconstitution of the partnership firm. This changes an end of the existing agreement and a new agreement comes into being with a changed relationship among the members of the partnership firm and/or their composition. However, the firm continues. The partners often resort to reconstitution of the firm in various ways such as admission of a new partner, change in profit sharing ratio, retirement of a partner, death or insolvence of a partner.

Modes of Reconstitution of a Partnership Firm

Reconstitution of a partnership firm usually takes place in any of the following ways:

1. Admission of a new partner: A new partner may be admitted when the firm needs additional capital or managerial help. According to the provisions of Partnership Act 1932 unless it is otherwise provided in the partnership deed a new partner can be admitted only when the existing partners unanimously agree for it.

2. Change in the profit sharing ratio among the existing partners: Sometimes the partners of a firm may decide to change their existing profit sharing ratio. This may happen an account of a change in the existing partners’ role in the firm.

3.Retirement of an existing partner: It means withdrawal by a partner from the business of the firm which may be due to his bad health, old age or change in business interests. In fact a partner can retire any time if the partnership is at will.

4.Death of a partner: Partnership may also stand reconstituted on death of a partner, if the remaining partners decide to continue the business of the firm as usual.

ADMISSION OF A NEW PARTNER

When firm requires additional capital or managerial help or both for the expansion of its business a new partner may be admitted to supplement its existing resources. According to the Partnership Act 1932, a new partner can be admitted into the firm only with the consent of all the existing partners unless otherwise agreed upon. With the admission of a new partner, the partnership firm is reconstituted and a new agreement is entered into to carry on the business of the firm. A newly admitted partner acquires two main rights in the firm–

1. Right to share the assets of the partnership firm; and

2. Right to share the profits of the partnership firm.

For the right to acquire share in the assets and profits of the partnership firm, the partner brings an agreed amount of capital either in cash or in kind. Moreover, in the case of an established firm which may be earning more profits than the normal rate of return on its capital the new partner is required to contribute some additional amount known as premium or goodwill. This is done primarily to compensate the existing partners for loss of their share in super profits of the firm.

Following are the other important points which require attention at the time of admission of a new partner:

1. New profit sharing ratio;

2. Sacrificing ratio;

3. Valuation and adjustment of goodwill;

4. Revaluation of assets and Reassessment of liabilities;

5. Distribution of accumulated profits (reserves); and

6. Adjustment of partners’ capitals.

NEW PROFIT SHARING RATIO

At the time of admission of a new partner, the old partners sacrifice a share of their profit in favour of the new partner. After they admit the new partner sharing of profit will be as per the calculated new profit sharing ratio. But, what will be the share of new partner and how he will acquire it from the existing partners is decided mutually among the old partners and the new partner. However, if nothing is specified as to how the new partner acquires his share from the old partners; it may be assumed that he gets it from them in their profit sharing ratio. In any case, on admission of a new partner, the profit sharing ratio among the old partners will change keeping in view their respective contribution to the profit sharing ratio of the incoming partner. Hence, there is a need to ascertain the new profit sharing ratio among all the partners. This depends upon how does the new partner acquires his share from the old partners for which there are many possibilities. Let us understand it with the help of the following illustrations.

SACRIFICING RATIO

The ratio in which the old partners agree to sacrifice their share of profit in favour of the incoming partner is called sacrificing ratio. The sacrifice by a partner is equal to :

Sacrificing Ratio = Old Share of Profit – New Share of Profit

As stated earlier, the new partner is required to compensate the old partner’s for their loss of share in the super profits of the firm for which he brings in an additional amount known as premium or goodwill. This amount is shared by the existing partners in the ratio in which they forego their shares in favour of the new partner which is called sacrificing ratio.

The ratio is normally clearly given as agreed among the partners which could be the old ratio, equal sacrifice, or a specified ratio. The difficulty arises where the ratio in which the new partner acquires his share from the old partners is not specified. Instead, the new profit sharing ratio is given. In such a situation, the sacrificing ratio is to be worked out by deducting each partner’s new share from his old share.

TREATMENT OF GOODWILL

The incoming partner who acquires his share in the profits of the firm from the existing partners brings in some additional amount to compensate them for loss of their share in super profits. It is termed as his share of goodwill (also called premium). Alternatively he may agree that goodwill account be raised in the books of the firm by giving the necessary credit to the old partners. Thus, when a new partner is admitted, goodwill can be treated in two ways: (1) By Premium Method, and (2) By Revaluation Method.

1.Premium Method

This method is followed when the new partner pays his share of goodwill in cash. The amount of premium brought in by the new partner is shared by the existing partners in their ratio of sacrifice. If this amount is paid to the old partners directly (privately) by the new partner, no entry is made in the books of the firm. But, when the amount is paid through the firm, the following journal entries are passed:    

                             Cash A/c Dr.

To Goodwill A/c

(Amount brought by new partner as premium)

Goodwill A/c Dr.

To Existing Partners Capital A/c (Individually)

(Goodwill distributed among the existing partners in their sacrificing ratio)

Alternatively, it is credited to the new partner’s capital account and then adjusted in favour of the existing partners in their sacrificing ratio. In that case the journal entries will be as follows:

Cash A/c Dr.

To New Partner’s Capital A/c

(Amount brought by new partner for his share of goodwill)

New Partner’s Capital A/c Dr.

To Existing Partner’s Capital A/cs (Individually)

(Goodwill brought by new partners distributed among the existing partners in their sacrificing ratio)

If the partners decide that the amount of premium credited to their capital accounts should be retained in business, there is no need to pass any additional entry. If, however, they decide to withdraw their amounts, (in full or in part) the following additional entry will be passed:

Existing Partner’s Capital A/c (Individually) Dr.

To Cash A/c

(The amount of goodwill withdrawn by the existing partners)

When goodwill already exists in books: The above treatment of goodwill was based on the assumption that there was no goodwill account in the books of the firm. However, It is quite possible that when a new partner brings in his share of goodwill in cash, some amount of goodwill already exists in books. In that case, after crediting the old partners by the amount of goodwill brought in by the new partner, the existing goodwill must be written off by debiting the old partners in their old profit sharing ratio. But, if it is decided that the goodwill may continue to appear in the books at its old value, the amount to be brought in by new partner will have to be proportionately reduced i.e., He will be required to bring cash only for this share of the excess of the agreed value of goodwill over the amount of goodwill already appearing in books.

Old Partner’s Capital A/Cs Dr.

To Goodwill A/c

(Goodwill written-off in old ratio)

2.Revaluation Method

This method is followed when the new partner does not bring in his share of goodwill in cash. In such a situation, the goodwill account is raised in the books of account by crediting the old partners in the old profit sharing ratio. When goodwill account is to be raised in the books of account there are two possibilities,

(a) No goodwill appears in books at the time of admission, and

(b) Goodwill already exists in books at the time of admission.

 (a) When no goodwill exists in the books: When no goodwill exists in the books at the time of the admission of a new partner, the goodwill account must be raised at its full value. This can be done by debiting goodwill account with its full value and crediting the old partners’ capital accounts in their profit sharing ratio. The journal entry will be:

Goodwill A/c Dr.

To Old Partners’ Capitals A/c (individually)

(Goodwill raised at full value in the old ratio)

The goodwill thus raised shall appear in the balance sheet of the firm at its full value.

(b) When goodwill already exists in the books : If the books already show some balance in the Goodwill Account, the adjustment for goodwill in the old partner’s capital accounts shall be made only for the difference between the agreed value of goodwill and the amount of goodwill appearing in books. The amount of goodwill appearing in the books may be less than its agreed value or it may be more than the agreed value. If it is less than the agreed value, the difference between the agreed value of goodwill and the amount of goodwill appearing in the books will be debited to goodwill account and credited to old partner’s capital accounts in their old profit sharing ratio. If, however, it is more than the agreed value, the difference will be debited to the old partners’ capital accounts in their old profits sharing ratio and credited to the goodwill account.

Thus, the journal entries will be as under:

(a) When the value of goodwill appearing in the books is less than the agreed value.

Goodwill A/c Dr.

To Old Partners’ Capital A/c (individually)

(Goodwill raised to its agreed value)

(b) When the value of goodwill appearing in the books is more than the agreed value.

Old Partners’ Capital A/c (individually) Dr.

To Goodwill A/c

(Goodwill brought down to its agreed value)

HIDDEN GOODWILL

Sometimes the value of goodwill is not given at the time of admission of a new partner. In such a situation it has to be inferred from the arrangement of the capital and profit sharing ratio.

ADJUSTMENT FOR ACCUMULATED PROFITS AND LOSSES

Sometimes a firm may have accumulated profits not yet transferred to capital accounts of the partners. These are usually in the firm of general reserve, reserve fund and/or Profit and Loss Account balance. The new partner is not entitled to have any share in such accumulated profits. These are distributed among the partners by transferring it to their capital accounts in old profit sharing ratio. Similarly, if there are some accumulated losses in the form of a debit balance of profit and loss account appearing in the balance sheet of the firm.

REVALUATION OF ASSETS AND REASSESSMENT OF LIABILITIES

At the time of admission of a new partner, it is always desirable to ascertain whether the assets of the firm are shown in books at their current values. In case the assets are overstated or understated, these are revalued. Similarly, a reassessment of the liabilities is also done so that these are brought in the books at their correct values. At times there may also be some unrecorded assets and liabilities of the firm. These also have to be brought into the books of the firm. For this purpose the firm has to prepare the Revaluation Account. The gain or loss on revaluation of each asset and liability is transferred to this account and finally its balance is transferred to the capital accounts of the old partners in their old profit sharing ratio. 

The revaluation account is credited with increase in the value of each asset and decrease in its liabilities because it is a gain and is debited with decrease in the value of assets and increase in its liabilities is debited to revaluation account because it is a loss. Similarly unrecorded assets are credited and unrecorded liabilities are debited to the revaluation account. If the revaluation account finally shows a credit balance then it indicates net gain and if there is a debit balance then it indicates net loss. Which will be transferred to the capital accounts of the old partners in old ratio.

The journal entries recorded for revaluation of assets and reassessment of liabilities are as follows:

(i) For increase in the value of an asset

Asset A/c Dr.

To Revaluation A/c (Gain)

(ii) For reduction in the value of an asset

Revaluation A/c Dr.

To Asset A/c (Loss)

(iii) For appreciation in the amount of a liability

Revaluation A/c Dr.

To Liability A/c (Loss)

(iv) For reduction in the amount of a liability

Liability A/c Dr.

To Revaluation A/c (Gain)

(v) For an unrecorded asset

Cash A/c Dr.

To Revaluation A/c (Gain)

(vi) For an unrecorded liability

Revaluation A/c Dr.

To Cash A/c (Loss)

(vii) For transfer of gain on Revaluation if credit balance

Revaluation A/c Dr.

To Old Partners Capital A/cs (Old ratio)

(individually)

(viii) For transferring loss on revaluation

Old partner’s Capital A/cs Dr.(Individually) (Old ratio)

To Revaluation A/c

The format of Revaluation account is given bellow

Revaluation A/C

Dr.                                                                                                Cr.

Particular	Amount	Particular	Amount
Decrease in Assets Increase in Liabilities Provision for doubtful debts Unrecorded liabilities Profit transferred to partner's capital a/c	XXX XXX XXX XXX XXX	Increase in Assets Decrease in Liabilities Unrecorded Assets Loss (if any) transferred to partner's capital a/c	XXX XXX XXX XXX XXX
	XXXX		XXXX

ADJUSTMENT OF PARTNER’S CAPITALS

Proportionate Capital Brought by The New Partner

          The proportionate capital brought by new partner will be calculated by adjusting the old partner’s capitals. After making all the adjustments in revaluation account the balance amounts will be shared in between old partners in the old profit ratio. After making the adjustments in capital account we have to find out the balance. The balance capital will be adjusted in proportion to the share of newly admitted partner.

 Old Partner’s Capitals Adjusted on The Basis of New Partner’s Capital

           In such a case the total capital of the firm will be calculated after the admission of new partner. For sharing the total capital, the new profit sharing ratio will calculate. After sharing the newly calculated capital asper the new profit sharing ratio , excess amounts is either paid off immediately or credited to the partner’s current account.  

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