Class 12 Accountancy Notes Chapter 3 (Reconstitution of a Partnership Firm – Admission of a Partner) – Accountancy-I Book

Detailed Notes with MCQs of a very important chapter for your upcoming exams: Chapter 3 - Reconstitution of a Partnership Firm – Admission of a Partner. This chapter deals with the changes in the partnership agreement when a new person joins the existing firm. Understanding the adjustments required is crucial.

1. Meaning of Reconstitution and Admission

• Reconstitution: Any change in the existing agreement (Partnership Deed) of a partnership firm leads to its reconstitution. This results in the end of the existing agreement and the beginning of a new one among the partners (including incoming or outgoing ones, if any).
• Admission of a Partner: This is one mode of reconstitution where a new person joins the existing partnership firm as a partner. According to Section 31(1) of the Indian Partnership Act, 1932, a new partner can be admitted only with the consent of all existing partners, unless otherwise agreed upon.
• Why Admit a New Partner? Usually, a new partner is admitted to:
  • Increase the capital resources of the firm.
  • Utilize the managerial skills or expertise of the new partner.
  • Expand the business.
  • Enhance the reputation/goodwill of the firm.

2. Main Adjustments Required on Admission

When a new partner is admitted, several accounting adjustments are necessary to settle the rights of the old partners and determine the new relationship. These are:

a.  Calculation of New Profit Sharing Ratio (NPSR) and Sacrificing Ratio (SR).
b.  Accounting Treatment of Goodwill.
c.  Accounting Treatment for Revaluation of Assets and Reassessment of Liabilities.
d.  Accounting Treatment of Accumulated Profits, Reserves, and Losses.
e.  Adjustment of Partners' Capitals (if agreed upon).

Let's break these down:

a) New Profit Sharing Ratio (NPSR) and Sacrificing Ratio (SR)

• NPSR: The ratio in which all partners (including the new one) will share future profits and losses of the reconstituted firm. The new partner acquires their share of profit from the old partners.
• Sacrificing Ratio (SR): The ratio in which the old partners agree to sacrifice their share of profit in favour of the new partner. This ratio is crucial because the new partner compensates the sacrificing partners for this loss through their share of goodwill.
  • Formula: Sacrificing Ratio = Old Profit Sharing Ratio (OPSR) - New Profit Sharing Ratio (NPSR)
• Calculation of NPSR - Common Scenarios:
  • Scenario 1: When only the new partner's share is given, and the sacrifice by old partners is not specified. It's assumed old partners sacrifice in their OPSR.
    • Method: Let total profit be 1. Calculate the remaining share (1 - New Partner's Share). Distribute this remaining share among old partners in their OPSR.
  • Scenario 2: When the new partner acquires their share from old partners in a specific ratio.
    • Method: Calculate the share sacrificed by each old partner (Old Partner's Sacrifice = New Partner's Share × Proportion of Sacrifice). Calculate the New Share for each old partner (Old Partner's New Share = Old Share - Share Sacrificed).
  • Scenario 3: When old partners surrender a specific fraction of their own share.
    • Method: Calculate the share sacrificed by each old partner (Sacrifice = Old Partner's Old Share × Fraction Surrendered). Calculate the New Share for each old partner (Old Partner's New Share = Old Share - Share Sacrificed). Calculate the New Partner's Share by summing up the sacrifices made by all old partners.

b) Accounting Treatment of Goodwill

• Goodwill: The value of the reputation of a firm which enables it to earn higher profits than the normal profits earned by other firms in the same trade. It's an intangible asset.
• Need for Valuation: At the time of admission, the new partner benefits from the firm's existing reputation built by the old partners. Therefore, the new partner compensates the old partners (in their sacrificing ratio) for acquiring a share in these future super-profits.
• Accounting Standard 26 (AS 26): This standard deals with Intangible Assets. It states that goodwill should be recorded in the books only when consideration in money or money's worth has been paid for it. Therefore, self-generated goodwill is not recorded as an asset. However, at the time of admission, adjustments for goodwill are made through partners' capital accounts or by cash brought in. Purchased goodwill (when a business is bought) can be recorded.
• Treatment Scenarios:
  • Scenario 1: Goodwill (Premium) paid privately: No entry in the books of the firm.
  • Scenario 2: Goodwill (Premium) brought in cash/kind by the new partner and retained in the business:
    1. Entry for cash/asset brought in:
       Cash/Bank A/c Dr.
       [or Specific Asset A/c Dr.]
       To Premium for Goodwill A/c
       To New Partner's Capital A/c (for capital contribution)
    2. Entry for distributing premium among sacrificing partners:
       Premium for Goodwill A/c Dr.
       To Old Partners' Capital/Current A/cs (in Sacrificing Ratio)
  • Scenario 3: Goodwill (Premium) brought in cash by the new partner and withdrawn by sacrificing partners:
    1. Entries as in Scenario 2 (above).
    2. Additional entry for withdrawal:
       Old Partners' Capital/Current A/cs Dr. (Individually, amount withdrawn)
       To Cash/Bank A/c
  • Scenario 4: New partner is unable to bring their share of goodwill in cash (or brings only a part): As per AS 26, goodwill cannot be raised. The adjustment is made through capital accounts.
    • Entry:
      New Partner's Current A/c Dr. (With their share of goodwill not brought in)
      To Old Partners' Capital/Current A/cs (in Sacrificing Ratio)
      (Note: Using the Current A/c prevents the new partner's capital from falling below the agreed amount. If Current accounts are not maintained, Capital A/c can be debited.)
  • Scenario 5: Existing Goodwill in the Books: If goodwill already appears in the balance sheet before admission, it must be written off among the old partners in their old profit sharing ratio.
    • Entry:
      Old Partners' Capital/Current A/cs Dr. (in OPSR)
      To Goodwill A/c
  • Hidden Goodwill: Sometimes the value of goodwill is not explicitly stated. It's inferred from the arrangement. For example, if the new partner's capital contribution implies a total firm capital higher than the combined adjusted capitals of all partners (including the new one), the difference can be treated as hidden goodwill.

c) Accounting Treatment for Revaluation of Assets and Reassessment of Liabilities

• Purpose: At the time of admission, assets and liabilities are revalued to their current market values. This ensures that the new partner is not affected by past fluctuations in value, and the old partners get the benefit (or bear the loss) of such changes up to the date of admission.
• Mechanism: A nominal account called Revaluation Account (also known as Profit and Loss Adjustment Account) is opened.
  • Debit Side: Records decrease in the value of assets and increase in the value of liabilities (losses).
  • Credit Side: Records increase in the value of assets and decrease in the value of liabilities (gains).
  • Unrecorded Assets: Credited to Revaluation A/c.
  • Unrecorded Liabilities: Debited to Revaluation A/c.
• Balancing:
  • If Credit side > Debit side = Revaluation Profit.
  • If Debit side > Credit side = Revaluation Loss.
• Distribution: The net profit or loss on revaluation belongs to the old partners and is transferred to their capital/current accounts in their old profit sharing ratio.
  • Entry for Profit:
    Revaluation A/c Dr.
    To Old Partners' Capital/Current A/cs (in OPSR)
  • Entry for Loss:
    Old Partners' Capital/Current A/cs Dr. (in OPSR)
    To Revaluation A/c

d) Accounting Treatment of Accumulated Profits, Reserves, and Losses

• Purpose: Past undistributed profits (like General Reserve, Profit & Loss A/c Credit Balance) or losses (Profit & Loss A/c Debit Balance, Deferred Revenue Expenditure) belong to the partners before reconstitution. These must be distributed among the old partners in their old profit sharing ratio before the new partner joins, so the new partner doesn't get a share in past profits/losses.
• Entries:
  • For distributing accumulated profits/reserves:
    General Reserve A/c Dr.
    Profit & Loss A/c (Cr. Balance) Dr.
    Workmen Compensation Reserve A/c Dr. (Excess over claim, if any)
    Investment Fluctuation Reserve A/c Dr. (Excess over fall in value, if any)
    To Old Partners' Capital/Current A/cs (in OPSR)
  • For distributing accumulated losses:
    Old Partners' Capital/Current A/cs Dr. (in OPSR)
    To Profit & Loss A/c (Dr. Balance)
    To Deferred Revenue Expenditure A/c (e.g., Advertisement Suspense)
• Specific Reserves:
  • Workmen Compensation Reserve (WCR): If there's a claim, transfer the amount of claim to "Provision for WCR Claim A/c" (liability). The balance (if any) is distributed among old partners. If the claim exceeds the reserve, the excess is debited to Revaluation A/c.
  • Investment Fluctuation Reserve (IFR): If the market value of investments falls, the difference (up to the reserve amount) is adjusted against IFR. Any remaining IFR is distributed among old partners. If the fall in value exceeds IFR, the excess is debited to Revaluation A/c. If market value increases, the entire IFR is distributed.

e) Adjustment of Partners' Capitals

• Sometimes, partners agree that their capitals in the reconstituted firm should be proportionate to their new profit sharing ratio.
• Methods:
  • Method 1: Based on New Partner's Capital: Calculate the total capital of the new firm based on the new partner's capital and their profit share. Then, determine the required capital for each old partner based on their NPSR. Compare this with their adjusted existing capital (after all adjustments for goodwill, revaluation, reserves etc.). The difference (surplus/deficit) is adjusted by bringing in or withdrawing cash, or through Current Accounts.
  • Method 2: Based on Old Partners' Adjusted Capitals: Calculate the total adjusted capital of the old partners. Determine the total capital of the new firm based on this amount and the old partners' combined share in the new firm. Calculate the required capital for the new partner based on their NPSR and the total capital. Then proceed as in Method 1 for adjusting old partners' capitals if needed (though often the focus here is finding the new partner's required capital).
• Adjustment Entry:
  • For bringing in cash (deficit): Cash/Bank A/c Dr. To Partner's Capital/Current A/c
  • For withdrawing cash (surplus): Partner's Capital/Current A/c Dr. To Cash/Bank A/c
  • If adjusted through Current Accounts: Use Partner's Current A/c instead of Cash/Bank A/c.

Sequence of Steps in Problem Solving:

1. Calculate Sacrificing Ratio and New Profit Sharing Ratio.
2. Adjust for Goodwill (pass necessary journal entries/adjust through capital accounts).
3. Prepare Revaluation Account and transfer profit/loss to Old Partners' Capital/Current A/cs (in OPSR).
4. Distribute Accumulated Profits/Reserves/Losses to Old Partners' Capital/Current A/cs (in OPSR).
5. Adjust Partners' Capitals (if required) based on NPSR.
6. Prepare Partners' Capital/Current Accounts.
7. Prepare the Balance Sheet of the reconstituted firm.

Remember to read the question carefully to understand which adjustments are required and how capitals (if specified) need to be adjusted. Pay close attention to the ratios (OPSR, NPSR, SR) and the accounts (Capital vs Current) to be used.

Multiple Choice Questions (MCQs)

1. A new partner can be admitted into a partnership firm:
   a) With the consent of any one partner.
   b) With the consent of the majority of partners.
   c. With the consent of all existing partners.
   d) With the consent of partners holding the majority share.

2. The ratio in which old partners surrender their share of profits in favour of a new partner is called:
   a) New Profit Sharing Ratio
   b) Capital Ratio
   c) Gaining Ratio
   d) Sacrificing Ratio

3. A and B are partners sharing profits in the ratio of 3:2. They admit C for 1/4th share. The sacrificing ratio of A and B will be:
   a) 1:1
   b) 2:3
   c) 3:2
   d) 4:1

4. When a new partner brings their share of goodwill in cash, the amount is debited to Cash/Bank A/c and credited to:
   a) New Partner's Capital A/c
   b) Premium for Goodwill A/c
   c) Old Partners' Capital A/cs
   d) Revaluation A/c

5. If, at the time of admission, some goodwill already exists in the books, it should be written off among the old partners in their:
   a) New Profit Sharing Ratio
   b) Sacrificing Ratio
   c) Old Profit Sharing Ratio
   d) Capital Ratio

6. Profit or loss on revaluation of assets and reassessment of liabilities at the time of admission is transferred to:
   a) All Partners' Capital A/cs in New Ratio
   b) Old Partners' Capital A/cs in Old Ratio
   c) Old Partners' Capital A/cs in Sacrificing Ratio
   d) Revaluation Reserve A/c

7. General Reserve appearing in the Balance Sheet at the time of admission of a partner is transferred to:
   a) Revaluation Account
   b) All Partners' Capital Accounts in New Ratio
   c) Old Partners' Capital Accounts in Old Ratio
   d) Profit & Loss Adjustment Account

8. X and Y are partners sharing profits 2:1. Z is admitted for 1/3rd share. Z brings ₹50,000 as capital but is unable to bring his share of goodwill of ₹15,000 in cash. How will the goodwill be treated?
   a) Goodwill A/c Dr. ₹15,000 To X's Capital ₹10,000 To Y's Capital ₹5,000
   b) Z's Current A/c Dr. ₹15,000 To X's Capital ₹10,000 To Y's Capital ₹5,000
   c) Premium for Goodwill A/c Dr. ₹15,000 To X's Capital ₹10,000 To Y's Capital ₹5,000
   d) Z's Capital A/c Dr. ₹15,000 To X's Capital ₹10,000 To Y's Capital ₹5,000

9. An increase in the value of liabilities at the time of admission of a partner is:
   a) Credited to Revaluation Account
   b) Debited to Revaluation Account
   c) Credited to Old Partners' Capital Accounts
   d) Debited to New Partner's Capital Account

10. A and B are partners with capitals of ₹60,000 and ₹40,000 respectively, sharing profits 3:2. C is admitted for 1/5th share and brings ₹50,000 as capital. If capitals are to be proportionate to the profit-sharing ratio based on C's capital, what is the total capital of the new firm?
    a) ₹1,50,000
    b) ₹2,00,000
    c) ₹2,50,000
    d) ₹1,00,000

Answer Key for MCQs:

1. c) With the consent of all existing partners.
2. d) Sacrificing Ratio
3. c) 3:2 (When only the new partner's share is given, it's assumed old partners sacrifice in their old ratio).
4. b) Premium for Goodwill A/c
5. c) Old Profit Sharing Ratio
6. b) Old Partners' Capital A/cs in Old Ratio
7. c) Old Partners' Capital Accounts in Old Ratio
8. b) Z's Current A/c Dr. ₹15,000 To X's Capital ₹10,000 To Y's Capital ₹5,000 (Sacrificing ratio is the old ratio 2:1 here. Adjustment via Current A/c is preferred as per AS 26 implications).
9. b) Debited to Revaluation Account
10. c) ₹2,50,000 (C's capital is ₹50,000 for 1/5th share. Total Capital = 50,000 × 5/1 = ₹2,50,000).

Study these notes thoroughly. Focus on understanding the why behind each adjustment, not just the mechanics. Practice numerical problems covering all these adjustments. Good luck!