Reconstitution of a Partnership Firm — Admission of a Partner

Reconstitution of a Partnership Firm: • Any change in the existing agreement of partnership is called reconstitution • When new partnership agreement comes into force, old partnership comes to an end and a new partnership comes into existence • The firm continues — it is only the relationship among partners that changes Situations requiring reconstitution: 1. Admission of a new partner 2. Retirement of an existing partner 3. Death of a partner 4. Change in profit sharing ratio among existing partners 5. Insolvency/expulsion of a partner Why reconstitution matters: • Assets need to be revalued to current market values • Goodwill needs to be assessed and adjusted • Sacrificing/gaining partners need to be compensated • Capital accounts need to be adjusted • New profit sharing ratio must be determined

Sacrificing Ratio: • The ratio in which the old partners sacrifice their share of profit in favour of the new/incoming partner • When a new partner joins, existing partners give up a portion of their profit share • The partners who give up profit are said to 'sacrifice' Formula: Sacrificing Ratio = Old Ratio − New Ratio (calculated for each old partner) Example: A and B share profits 3:2. New partner C admitted. New ratio A:B:C = 3:2:1 (total 6) A's old share = 3/5; A's new share = 3/6; A's sacrifice = 3/5 − 3/6 = 18/30 − 15/30 = 3/30 B's old share = 2/5; B's new share = 2/6; B's sacrifice = 2/5 − 2/6 = 12/30 − 10/30 = 2/30 Sacrificing ratio A:B = 3:2 (same as old ratio if profit share is surrendered proportionately) Gaining Ratio: • The ratio in which the remaining partners gain the share of the retiring/deceased partner • Used at the time of retirement or death of a partner Formula: Gaining Ratio = New Ratio − Old Ratio (calculated for each remaining partner) Example: A, B, C share profits 2:2:1. C retires. A and B share new profits 3:2. A's gain = 3/5 − 2/5 = 1/5 B's gain = 2/5 − 2/5 = 0 Gaining ratio = 1:0 (only A gains) Importance: • Sacrificing partners are COMPENSATED by the new partner via goodwill • Gaining partners COMPENSATE the retiring partner via goodwill

Goodwill: • The value of the reputation, business connections, and brand name of a firm • It represents the ability of the business to earn above-normal profits due to its past efforts and reputation • An intangible asset • ICAI definition: 'The present value of a firm's anticipated excess earnings' Factors affecting goodwill: 1. Nature of business (stable, essential goods = higher goodwill) 2. Location (prime location = higher goodwill) 3. Management quality and efficiency 4. Past profit trends (consistent high profits = higher goodwill) 5. Brand name, trademarks, patents 6. Customer loyalty and relationships 7. Efficient staff 8. Favourable government regulations 9. Market competition (less competition = higher goodwill) Methods of valuation of goodwill: 1. Average Profit Method: Goodwill = Average Annual Profit × Number of Years' Purchase Average Profit = Total Profits of past years / Number of years If adjusted profits (excluding abnormal items) are used → Weighted Average Profit Method 2. Super Profit Method: Super Profit = Average Profit − Normal Profit Normal Profit = Capital Employed × Normal Rate of Return / 100 Goodwill = Super Profit × Number of Years' Purchase 3. Capitalisation Method: (a) Capitalisation of Average Profit: Goodwill = Average Profit × 100/Normal Rate of Return − Actual Capital Employed OR Capitalised Value = Average Profit / Normal Rate of Return × 100 (b) Capitalisation of Super Profit: Goodwill = Super Profit / Normal Rate of Return × 100 4. Annuity Method: Goodwill = Super Profit × Annuity Value (from tables)

Given: Old ratio A:B:C = 5:3:2 D admitted for 1/5 share D's share contributed equally by A, B, and C D's share = 1/5 Each old partner sacrifices 1/3 of D's share Each old partner's sacrifice = 1/3 × 1/5 = 1/15 New shares: A's new share = 5/10 − 1/15 = 15/30 − 2/30 = 13/30 B's new share = 3/10 − 1/15 = 9/30 − 2/30 = 7/30 C's new share = 2/10 − 1/15 = 6/30 − 2/30 = 4/30 D's new share = 1/5 = 6/30 Verification: 13/30 + 7/30 + 4/30 + 6/30 = 30/30 = 1 ✓ New profit sharing ratio A:B:C:D = 13:7:4:6 Sacrificing ratio: A's sacrifice = 1/15 B's sacrifice = 1/15 C's sacrifice = 1/15 Sacrificing ratio A:B:C = 1:1:1 (equal sacrifice)

Given: Old ratio Raj:Mohan = 3:2 New partner Rita admitted for 1/4 share Goodwill of firm = ₹80,000 Rita's share of goodwill = 1/4 × ₹80,000 = ₹20,000 Sacrificing ratio (Raj:Mohan): Raj sacrifices = 3/5 of Rita's share = 3/5 × 1/4 = 3/20 Mohan sacrifices = 2/5 × 1/4 = 2/20 Sacrificing ratio = 3:2 (same as old ratio) Raj's share of goodwill = 3/5 × ₹20,000 = ₹12,000 Mohan's share of goodwill = 2/5 × ₹20,000 = ₹8,000 (a) When goodwill is NOT to appear in books (most common — AS 26): Journal Entries: 1. Rita brings goodwill in cash: Bank A/c Dr. 20,000 To Rita's Capital A/c 20,000 (Being goodwill brought by Rita in cash) 2. Goodwill distributed to sacrificing partners: Rita's Capital A/c Dr. 20,000 To Raj's Capital A/c 12,000 To Mohan's Capital A/c 8,000 (Being goodwill credited to Raj and Mohan in sacrificing ratio) 3. Rita's capital introduced: Bank A/c Dr. 60,000 To Rita's Capital A/c 60,000 (b) When Goodwill Account is to be RAISED at full value (₹80,000): 1. Raising goodwill: Goodwill A/c Dr. 80,000 To Raj's Capital A/c 48,000 To Mohan's Capital A/c 32,000 (Being goodwill raised in old ratio 3:2) 2. Rita brings her share: Bank A/c Dr. 80,000 To Rita's Capital A/c 60,000 To Premium for Goodwill A/c 20,000 3. Premium distributed: Premium for Goodwill A/c Dr. 20,000 To Raj's Capital A/c 12,000 To Mohan's Capital A/c 8,000

At the time of admission of a new partner, assets and liabilities are revalued to their current fair market values. Purpose of Revaluation: • To ensure old partners get their correct share of profit/loss from changes in asset/liability values that occurred during their partnership • The new partner should neither benefit from past appreciation nor bear past losses Revaluation Account (Profit and Loss Adjustment Account): • A nominal account opened to record gains/losses on revaluation • Profit from revaluation = credited to old partners in old ratio • Loss from revaluation = debited to old partners in old ratio Journal Entries: 1. Increase in value of asset: Asset A/c Dr. [Amount] To Revaluation A/c [Amount] 2. Decrease in value of asset: Revaluation A/c Dr. [Amount] To Asset A/c [Amount] 3. Increase in liability: Revaluation A/c Dr. [Amount] To Liability A/c [Amount] 4. Decrease in liability: Liability A/c Dr. [Amount] To Revaluation A/c [Amount] 5. Unrecorded assets (e.g., investment): Asset A/c Dr. [Amount] To Revaluation A/c [Amount] 6. Unrecorded liabilities: Revaluation A/c Dr. [Amount] To Liability A/c [Amount] 7. Transfer of Revaluation Profit: Revaluation A/c Dr. [Total Profit] To Partner A's Capital A/c [Share] To Partner B's Capital A/c [Share] (In old profit sharing ratio) 7a. Transfer of Revaluation Loss: Partner A's Capital A/c Dr. [Share] Partner B's Capital A/c Dr. [Share] To Revaluation A/c [Total Loss] (In old profit sharing ratio)