CBSE Class 12 Accountancy: Reconstitution of a Partnership Firm (Admission of a Partner)

Understanding Reconstitution and Admission of a Partner

A partnership firm is said to be reconstituted when there is a change in the existing agreement among the partners. This change results in a new agreement and, consequently, a new partnership. One of the most common ways a partnership firm is reconstituted is through the admission of a new partner. This usually happens when a firm requires additional capital for expansion, desires specific expertise or managerial skills, or simply wishes to expand its business operations by bringing in a capable individual.

Upon the admission of a new partner, several fundamental changes occur within the firm. The old profit-sharing ratio among the existing partners changes, and a new profit-sharing ratio including the incoming partner must be determined. Additionally, the new partner typically compensates the old partners for giving up a share of the firm's future profits, usually in the form of goodwill. Furthermore, to ensure fairness and prevent the new partner from benefiting or suffering from past accumulated profits, losses, or changes in the value of assets and liabilities, a revaluation of assets and reassessment of liabilities is undertaken. Finally, the capital accounts of all partners may need adjustments to align with the new profit-sharing arrangement or other agreed terms.

Key Terms in Admission of a Partner

Reconstitution of a Partnership Firm

Any alteration in the partnership agreement which leads to a change in the relationship among partners but the firm continues its business. Examples include admission, retirement, or death of a partner.

Admission of a Partner

The process of inducting a new person into an existing partnership firm. As per Section 31 of the Indian Partnership Act, 1932, a new partner can be admitted only with the consent of all existing partners.

New Profit Sharing Ratio (NPSR)

The revised ratio in which all partners (old and new) agree to share future profits and losses of the firm after the admission of a new partner.

Sacrificing Ratio

The ratio in which the old partners agree to surrender or sacrifice a part of their share of profit in favour of the newly admitted partner. It is calculated as Old Share - New Share and is crucial for distributing goodwill.

Goodwill

The value of the reputation of a business, which enables it to earn super profits compared to other firms in the same industry. It's an intangible asset that arises from factors like location, quality of goods, management efficiency, etc.

Revaluation Account

A nominal account prepared at the time of reconstitution of a partnership to record the increase or decrease in the value of assets and liabilities. The net effect (profit or loss) is transferred to the old partners' capital accounts in their old profit-sharing ratio.

Calculating New Profit Sharing Ratio and Sacrificing Ratio

1. Step 1: Calculate New Profit Sharing Ratio (NPSR) — There are different scenarios for calculating the New Profit Sharing Ratio: Scenario A: New partner's share is given, and old partners share the remaining profit in their old ratio. 1. Assume the total profit of the firm is 1. 2. Deduct the new partner's share from 1 to find the remaining share. 3. Distribute this remaining share among the old partners in their old profit-sharing ratio. Scenario B: New partner acquires their share from old partners in a specified ratio or fraction. 1. Calculate the sacrifice made by each old partner (Old Partner's Share × Proportion given to new partner). 2. Subtract the sacrifice from each old partner's old share to find their new share. 3. Combine the new shares of old partners with the new partner's share to get the NPSR. Ensure all shares have a common denominator.
2. Step 2: Calculate Sacrificing Ratio — Once the New Profit Sharing Ratio for all partners is determined, the Sacrificing Ratio for the old partners can be calculated. This ratio is vital for distributing the premium for goodwill brought in by the new partner. Formula: Sacrificing Ratio = Old Share - New Share A positive result indicates a sacrifice. A negative result (gaining ratio) indicates a gain, meaning an old partner has actually increased their share, which is rare in admission but possible if terms are unusual. Goodwill is only distributed to sacrificing partners.

Accounting Treatment of Goodwill

• Example 1: Premium for Goodwill brought in cash and retained in the business.

  A and B are partners sharing profits in the ratio of 3:2. C is admitted for 1/5th share, which he acquires equally from A and B. C brings Rs. 50,000 as premium for goodwill and Rs. 1,00,000 as capital. Pass necessary journal entries.

  Step 1: Calculate New Profit Sharing Ratio (NPSR) and Sacrificing Ratio.
  C's share = 1/5.
  C acquires 1/10 from A (1/5 1/2) and 1/10 from B (1/5 1/2).
  Sacrificing Ratio of A and B = 1:1.
  New Share of A = 3/5 - 1/10 = 6/10 - 1/10 = 5/10.
  New Share of B = 2/5 - 1/10 = 4/10 - 1/10 = 3/10.
  New Share of C = 1/5 = 2/10.
  NPSR of A, B, C = 5:3:2.

  Step 2: Pass Journal Entries.

  Journal Entries
  | Date | Particulars | L.F. | Debit (Rs.) | Credit (Rs.) |
  |---|---|---|---:|---:|
  | | Bank A/c Dr. | | 1,50,000 | |
  | |     To C's Capital A/c | | | 1,00,000 |
  | |     To Premium for Goodwill A/c | | | 50,000 |
  | | (Being cash brought in by C for capital and premium for goodwill) | | | |
  | | Premium for Goodwill A/c Dr. | | 50,000 | |
  | |     To A's Capital A/c | | | 25,000 |
  | |     To B's Capital A/c | | | 25,000 |
  | | (Being premium for goodwill distributed among old partners in sacrificing ratio 1:1) | | | |

  Example 2: Premium for Goodwill not brought in cash.

  X and Y are partners sharing profits in 4:1. Z is admitted for 1/4th share. Z is unable to bring his share of goodwill, which is valued at Rs. 40,000. Pass journal entry for goodwill adjustment.

  Step 1: Calculate Sacrificing Ratio.
  In the absence of other information, the old ratio 4:1 is usually the sacrificing ratio.

  Step 2: Pass Journal Entry for goodwill adjustment.

  Journal Entry
  | Date | Particulars | L.F. | Debit (Rs.) | Credit (Rs.) |
  |---|---|---|---:|---:|
  | | Z's Current A/c Dr. | | 40,000 | |
  | |     To X's Capital A/c | | | 32,000 |
  | |     To Y's Capital A/c | | | 8,000 |
  | | (Being Z's share of goodwill adjusted through his current account, distributed in sacrificing ratio 4:1) | | | |

Revaluation of Assets and Reassessment of Liabilities

At the time of admitting a new partner, it becomes imperative to revalue the assets and reassess the liabilities of the firm. The primary reason for this exercise is to ensure that the newly admitted partner neither benefits from any undisclosed appreciation in the value of assets nor suffers from any undisclosed depreciation in the value of assets or increase in liabilities that occurred before their admission. Any profit or loss arising from such revaluation or reassessment rightly belongs to the old partners, as it relates to the period before the new partner joined.

The Revaluation Account is a nominal account created for this purpose. It is debited with all decreases in the value of assets and increases in the value of liabilities, as these represent losses. Conversely, it is credited with all increases in the value of assets and decreases in the value of liabilities, as these represent gains. The balance of the Revaluation Account (which can be a profit or a loss) is then transferred to the Capital Accounts of the old partners in their old profit-sharing ratio. This ensures that the financial effects of past changes in asset and liability values are settled among the original partners before the new partnership agreement takes effect.

Exam Traps and Important Tips for Admission of a Partner

When tackling questions on the admission of a partner, pay close attention to these common pitfalls:

1. Sacrificing Ratio is Key for Goodwill: Always remember that the premium for goodwill brought by the new partner is distributed among the old partners in their sacrificing ratio, not necessarily their old profit-sharing ratio. Calculate the sacrificing ratio carefully. If the new partner acquires their share directly from old partners in a specific ratio, that specific ratio is the sacrificing ratio.
2. Revaluation Profit/Loss Distribution: The profit or loss on revaluation of assets and liabilities must always be distributed among the old partners in their old profit-sharing ratio. The new partner has no claim on this as it pertains to values before their admission.
3. Hidden Goodwill: If the value of goodwill is not explicitly given, you might need to calculate 'Hidden Goodwill'. This is typically found by comparing the new partner's capital contribution for their share of profit with the proportionate capital of the entire firm.
4. Capital Adjustments: Read the question carefully regarding capital adjustments. Sometimes, the old partners' capitals are adjusted to be proportionate to the new partner's capital in the new profit-sharing ratio. Other times, the new partner's capital might be determined based on the adjusted capital of the old partners. Don't mix up the base for adjustment.
5. Accumulated Profits/Losses and Reserves: Don't forget to distribute any accumulated profits, losses, or reserves (like General Reserve, P&L Balance, Workers' Compensation Reserve, Investment Fluctuation Reserve) existing before admission, among the old partners in their old profit-sharing ratio. These belong to them before the new partner joins.

Practice Questions with Solutions

• Q: A and B are partners sharing profits in the ratio of 7:3. C is admitted as a new partner for 3/7th share in the profits, which he takes 2/7th from A and 1/7th from B. Calculate the new profit-sharing ratio and sacrificing ratio.
  A: Step 1: Calculate the new share of A.
  Old share of A = 7/10. Sacrifice by A = 2/7.
  New Share of A = 7/10 - 2/7 = (49 - 20) / 70 = 29/70.
  Step 2: Calculate the new share of B.
  Old share of B = 3/10. Sacrifice by B = 1/7.
  New Share of B = 3/10 - 1/7 = (21 - 10) / 70 = 11/70.
  Step 3: New share of C = 3/7 = 30/70 (to make denominator common).
  Step 4: Determine New Profit Sharing Ratio.
  New Profit Sharing Ratio of A, B, C = 29/70 : 11/70 : 30/70 or 29:11:30.
  Step 5: Determine Sacrificing Ratio.
  Sacrifice by A = 2/7. Sacrifice by B = 1/7.
  Sacrificing Ratio of A and B = 2:1.
  Final answer: New Profit Sharing Ratio = 29:11:30; Sacrificing Ratio = 2:1.

• Q: X and Y are partners sharing profits in the ratio of 3:2. They admit Z for 1/5th share in profits. Z brings Rs. 80,000 as capital and Rs. 20,000 as premium for goodwill. Pass necessary journal entries, assuming the premium for goodwill is withdrawn by old partners.
  A: Step 1: Calculate New Profit Sharing Ratio and Sacrificing Ratio.
  Assume total profit = 1. Remaining share for X and Y = 1 - 1/5 = 4/5.
  X's new share = (4/5) * (3/5) = 12/25.
  Y's new share = (4/5) * (2/5) = 8/25.
  Z's share = 1/5 = 5/25.
  NPSR of X, Y, Z = 12:8:5.
  In this case, the old ratio 3:2 is the sacrificing ratio (as Z gets his share proportionally from X and Y).
  Step 2: Pass Journal Entries.
  Journal Entries:
  | Date | Particulars | L.F. | Debit (Rs.) | Credit (Rs.) |
  |---|---|---|---:|---:|
  | | Bank A/c Dr. | | 1,00,000 | |
  | |     To Z's Capital A/c | | | 80,000 |
  | |     To Premium for Goodwill A/c | | | 20,000 |
  | | (Being cash brought in by Z for capital and premium for goodwill) | | | |
  | | Premium for Goodwill A/c Dr. | | 20,000 | |
  | |     To X's Capital A/c | | | 12,000 |
  | |     To Y's Capital A/c | | | 8,000 |
  | | (Being premium for goodwill distributed among X and Y in sacrificing ratio 3:2) | | | |
  | | X's Capital A/c Dr. | | 12,000 | |
  | | Y's Capital A/c Dr. | | 8,000 | |
  | |     To Bank A/c | | | 20,000 |
  | | (Being premium for goodwill withdrawn by X and Y) | | | |
  Final answer: Journal entries as above, reflecting capital and goodwill introduction, distribution, and withdrawal.

• Q: P and Q are partners sharing profits in 2:1. They admit R into partnership. The firm's assets and liabilities are revalued as follows: Stock to be reduced by Rs. 5,000, Machinery to be increased to Rs. 1,00,000 (its book value was Rs. 90,000), a provision for doubtful debts of 5% on debtors (Debtors Rs. 40,000) to be created, and a creditor of Rs. 2,000 is unrecorded. Prepare Revaluation Account.
  A: Step 1: Identify increases/decreases in assets/liabilities.
  Stock decrease = Rs. 5,000 (Loss).
  Machinery increase = Rs. 1,00,000 - Rs. 90,000 = Rs. 10,000 (Gain).
  Provision for doubtful debts = 5% of Rs. 40,000 = Rs. 2,000 (Increase in liability, Loss).
  Unrecorded Creditor = Rs. 2,000 (Increase in liability, Loss).
  Step 2: Prepare Revaluation Account.
  Revaluation Account
  | Particulars | Amount (Rs.) | Particulars | Amount (Rs.) |
  |---|---:|---|---:|
  | To Stock A/c | 5,000 | By Machinery A/c | 10,000 |
  | To Provision for Doubtful Debts A/c | 2,000 | | |
  | To Creditors A/c (Unrecorded) | 2,000 | | |
  | To Profit on Revaluation transferred to: | | | |
  |   P's Capital A/c (1,000 * 2/3) | 667 | | |
  |   Q's Capital A/c (1,000 * 1/3) | 333 | | |
  | | 10,000 | | 10,000 |
  (Calculation of Profit: Gains Rs. 10,000 - Losses Rs. (5,000 + 2,000 + 2,000) = Rs. 10,000 - Rs. 9,000 = Rs. 1,000. This profit is distributed to P and Q in their old ratio 2:1).
  Final answer: Revaluation Account showing a profit of Rs. 1,000, distributed to P and Q.

• Q: A, B, and C are partners sharing profits in 5:3:2. D is admitted into partnership for 1/4th share. D brings Rs. 1,50,000 as capital. The total capital of the firm is to be Rs. 6,00,000 after D's admission, and capitals of A, B, and C are to be adjusted on the basis of their new profit-sharing ratio. Pass necessary journal entries for capital adjustment if A's existing capital after all other adjustments is Rs. 3,00,000, B's is Rs. 1,80,000, and C's is Rs. 90,000.
  A: Step 1: Calculate New Profit Sharing Ratio.
  Remaining share for A, B, C = 1 - 1/4 = 3/4.
  New share of A = (3/4) * (5/10) = 15/40.
  New share of B = (3/4) * (3/10) = 9/40.
  New share of C = (3/4) * (2/10) = 6/40.
  New share of D = 1/4 = 10/40.
  NPSR of A, B, C, D = 15:9:6:10.
  Step 2: Calculate proportionate capital for A, B, C.
  Total capital of the firm = Rs. 6,00,000.
  Required Capital for A = Rs. 6,00,000 * (15/40) = Rs. 2,25,000.
  Required Capital for B = Rs. 6,00,000 * (9/40) = Rs. 1,35,000.
  Required Capital for C = Rs. 6,00,000 * (6/40) = Rs. 90,000.
  Step 3: Determine excess or deficit for each partner.
  A's existing capital = Rs. 3,00,000. Required = Rs. 2,25,000. A has surplus of Rs. 75,000 (Rs. 3,00,000 - Rs. 2,25,000).
  B's existing capital = Rs. 1,80,000. Required = Rs. 1,35,000. B has surplus of Rs. 45,000 (Rs. 1,80,000 - Rs. 1,35,000).
  C's existing capital = Rs. 90,000. Required = Rs. 90,000. C has no surplus/deficit.
  Step 4: Pass Journal Entries for capital adjustments.
  Journal Entries
  | Date | Particulars | L.F. | Debit (Rs.) | Credit (Rs.) |
  |---|---|---|---:|---:|
  | | Bank A/c Dr. | | 1,50,000 | |
  | |     To D's Capital A/c | | | 1,50,000 |
  | | (Being capital brought in by D) | | | |
  | | A's Capital A/c Dr. | | 75,000 | |
  | | B's Capital A/c Dr. | | 45,000 | |
  | |     To Bank A/c | | | 1,20,000 |
  | | (Being excess capital withdrawn by A and B) | | | |
  Final answer: Journal entries for D's capital and withdrawal of excess capital by A and B.

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