01 · Explore
Concept and Modes of Reconstitution
Partnership is an agreement between persons to share profits of a business. Any change in this existing agreement, while the firm continues, is termed as reconstitution.
Reconstitution results in the end of the existing agreement and the formation of a new one, changing the relationship among partners. The firm continues its business operations despite the change in its internal composition.
Common modes of reconstitution include the admission of a new partner, changes in the profit-sharing ratio among existing partners, retirement of a partner, or the death/insolvency of a partner. In all these cases, the old partnership deed is replaced by a new agreement.
According to the Partnership Act 1932, a new partner can generally be admitted only with the unanimous consent of all existing partners, unless the partnership deed provides otherwise. Admission usually occurs when the firm requires additional capital or managerial expertise.
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Question
Under what legal condition can a new partner be admitted if the partnership deed is silent?
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02 · Explore
New Profit Sharing Ratio
When a new partner is admitted, they acquire a share of profits from the old partners, necessitating the calculation of a new profit-sharing ratio for all members.
The new profit-sharing ratio depends on how the incoming partner acquires their share. If the agreement does not specify the source, it is assumed the new partner acquires their share from old partners in their old profit-sharing ratio.
To calculate the new ratio when the total share is 1: first, deduct the new partner's share from 1 to find the 'remaining share'. Then, multiply this remaining share by each old partner's individual old share to find their new respective shares.
Calculating New Ratio (Simple Case)
Remaining Share = 1 - 1/5 = 4/5; Anil's New Share = 3/5 * 4/5 = 12/25
Anil and Vishal share 3:2. Sumit is admitted for 1/5 share. Remaining share for old partners is 4/5. Anil's new share is 12/25, Vishal's is 8/25 (2/5 * 4/5), and Sumit's is 5/25. New Ratio = 12:8:5.
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If A and B (3:1) admit C for 1/4 share, what is the new profit sharing ratio?
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03 · Explore
Sacrificing Ratio
The sacrificing ratio is the proportion in which old partners forgo their profit shares in favor of the new partner.
The sacrifice made by an old partner is calculated as: Old Share of Profit minus New Share of Profit. This ratio is critical because the premium for goodwill brought by the new partner is distributed among old partners in this specific ratio.
If the new profit-sharing ratio is not provided, and only the new partner's share is mentioned, the sacrificing ratio is typically the same as the old profit-sharing ratio. However, if a specific new ratio is agreed upon, the sacrifice must be mathematically derived for each partner.
| Partner | Old Share | New Share | Sacrifice (Old - New) |
|---|---|---|---|
| Rohit | 5/8 | 4/7 | 3/56 |
| Mohit | 3/8 | 2/7 | 5/56 |
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Why is the sacrificing ratio calculated during the admission of a partner?
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04 · Explore
Nature and Valuation of Goodwill
Goodwill is an intangible asset representing the value of a firm's reputation that enables it to earn profits higher than the normal rate.
Goodwill arises from factors such as favorable location, efficient management, nature of business (stable demand), and special advantages like patents or trademarks. It is essentially the present value of anticipated excess earnings (super profits).
There are three primary methods for valuation: Average Profits Method (simple or weighted), Super Profits Method, and Capitalisation Method. The choice of method is usually decided mutually between partners.
Factors Affecting Goodwill Value
- 1
Location
Central location with high customer traffic increases value.
- 2
Management
Efficient management leads to higher productivity and cost efficiency.
- 3
Market Status
Monopoly or limited competition allows for higher profit margins.
Key business attributes that contribute to the monetary value of a firm's reputation.
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Does a firm incurring losses have goodwill?
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05 · Explore
Calculation Methods: Average and Super Profits
These methods use past performance to estimate the value of the 'years of purchase' a buyer is willing to pay for.
Under the Average Profits Method, goodwill = Average Profit × Number of Years' Purchase. Weighted average is used if profits show a clear increasing or decreasing trend, giving more weight to recent years.
The Super Profits Method focuses on profits earned in excess of the normal return on capital. Normal Profit = (Capital Employed × Normal Rate of Return) / 100. Super Profit = Actual Average Profit - Normal Profit. Goodwill = Super Profit × Number of Years' Purchase.
Super Profits Calculation
Normal Profit = 5,00,000 * 10% = 50,000; Super Profit = 60,000 - 50,000 = 10,000
Capital is 5,00,000 with 10% normal return. Average profit is 60,000. Goodwill at 3 years purchase = 10,000 * 3 = 30,000.
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Define 'Super Profits'.
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06 · Explore
Capitalisation Method
This method determines the value of goodwill by calculating the capital required to earn a certain level of profit.
Capitalisation of Average Profits: First, find the 'Capitalised Value of Average Profits' by (Average Profit × 100) / Normal Rate of Return. Then, Goodwill = Capitalised Value - Net Assets (Actual Capital).
Capitalisation of Super Profits: This directly capitalises the super profit. Goodwill = (Super Profit × 100) / Normal Rate of Return. Both capitalisation approaches yield the same goodwill value.
Capitalisation of Average Profits
Cap. Value = (1,00,000 * 100) / 10 = 10,00,000; Goodwill = 10,00,000 - 8,20,000 = 1,80,000
A firm earns 1,00,000 average profit with 10% normal rate. Net assets are 8,20,000. The goodwill is the difference between the capitalised value of its earnings and its actual capital.
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If Super Profit is 18,000 and the Normal Rate of Return is 10%, what is the goodwill using the capitalisation method?
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07 · Explore
Accounting Treatment of Goodwill
Goodwill treatment depends on whether the new partner brings the premium in cash and whether goodwill already exists in the books.
When the new partner brings goodwill in cash, the 'Premium for Goodwill A/c' is credited and then distributed to sacrificing partners' capital accounts in their sacrificing ratio. If they withdraw it, their capital accounts are debited and Bank A/c is credited.
If goodwill already exists in the balance sheet, it must be written off by debiting old partners' capital accounts in their old profit-sharing ratio before the new partner is admitted. According to AS 26, goodwill appearing in the balance sheet is written off at the time of firm's reconstitution.
Purchased goodwill may be accounted for in the books but should be written off as early as possible, not exceeding 10 years. If the new partner cannot bring goodwill in cash, the new partner's Current Account is debited for their share, and sacrificing partners' Capital Accounts are credited. This ensures the new partner's capital remains intact while compensating the old partners.
- 1
Debit Bank A/c and Credit Premium for Goodwill A/c for cash received.
- 2
Debit Premium for Goodwill A/c and Credit Sacrificing Partners' Capital A/cs in sacrificing ratio.
- 3
If existing goodwill is present, Debit Old Partners' Capital A/cs and Credit Goodwill A/c in old ratio.
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Question
In what ratio is the premium for goodwill brought by a new partner shared by existing partners?
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08 · Explore
Revaluation of Assets and Liabilities
On admission, assets and liabilities are revalued to ensure the new partner does not benefit from past gains or suffer from past losses.
A Revaluation Account (or Profit and Loss Adjustment Account) is prepared. It is credited with increases in asset values and decreases in liability values (gains). It is debited with decreases in asset values and increases in liability values (losses).
The net profit or loss from revaluation is transferred to the old partners' capital accounts in their old profit-sharing ratio. After revaluation, assets and liabilities appear in the new balance sheet at their revised values.
| Transaction | Account Debited | Account Credited |
|---|---|---|
| Increase in Asset Value | Asset A/c | Revaluation A/c |
| Decrease in Asset Value | Revaluation A/c | Asset A/c |
| Increase in Liability | Revaluation A/c | Liability A/c |
| Unrecorded Asset found | Asset A/c | Revaluation A/c |
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Where is the profit or loss on revaluation transferred?
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09 · Explore
Accumulated Profits, Losses, and Reserves
Reserves and undistributed profits appearing in the balance sheet belong to the old partners and must be adjusted.
Accumulated profits (General Reserve, Reserve Fund, P&L Cr. balance) are distributed to old partners by crediting their capital accounts in the old profit-sharing ratio. The new partner has no right to these past earnings.
Similarly, accumulated losses (P&L Dr. balance, Deferred Revenue Expenditure) are debited to the old partners' capital accounts in the old ratio. This ensures the new partner starts with a clean slate regarding the firm's historical reserves.
Adjusting General Reserve
Rajinder's share = 20,000 * 4/5 = 16,000; Surinder's share = 20,000 * 1/5 = 4,000
A firm has a 20,000 General Reserve. Rajinder and Surinder (4:1) admit Narender. The reserve is transferred to old partners' capital accounts before admission.
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In which ratio are accumulated profits distributed at the time of admission?
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10 · Explore
Adjustment of Partners' Capitals
Partners may agree to make their capital accounts proportionate to their new profit-sharing ratio.
If the new partner's capital is the base: Total capital of the firm = New Partner's Capital × Reciprocal of their share. This total is then divided among all partners in the new ratio.
The resulting figures are compared with existing adjusted capitals. Partners with a shortage bring in cash, while those with a surplus withdraw cash or have the amount transferred to their Current Accounts.
Alternatively, the total capital of the firm may be fixed by agreement. In this case, each partner's required capital is calculated based on their share of the fixed total, and adjustments are made accordingly.
The final capital balances of all partners will be exactly proportional to their new profit-sharing ratio.
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If C is admitted for 1/4 share with 20,000 capital, what is the total capital of the newly constituted firm based on C's share?
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