Changes in profit sharing ratio among the existing partners, Sacrificing Ratio and Gaining Ratio
Ø Accounting for revaluation of assets and liabilities and distribution of reserves and accumulated profits
Ø Goodwill: nature, factors affecting and methods of valuation, average profit, super profit and capitalization methods
Ø Admission of a Partner: Effect of admission of partner, change in profit sharing ratio, accounting treatment for goodwill, revaluation assets and liabilities, reserves (accumulated profits) and adjustment of capitals
A partnership business may undergo several structural changes during its lifetime. New partners may join or existing ones may leave the business. While making such major changes in the structure of business, partners carefully evaluate their accounts. They have to reset the system on a correct starting point. They check the values of assets and liabilities appearing in the books. If there are discrepancies they have to be rectified before introducing a major change. Reconstitution of a partnership business can take place under the following situations:
- Admission of a new partner
- Changing profit sharing ratio among existing partners
- Retirement / death of a partner
- Amalgamation of two partnership firms
The most important accounting adjustment is resetting of old accounts. It is a common adjustment in all cases of reconstitution. In this chapter you will find reconstitution by admission and reconstitution by changing ratios. Reconstitution by admission is more important on examination point of view. The following are the common adjustments at the time of reconstitution of a partnership business.
1. Revaluation of assets and liabilities
2. Distribution of reserves and accumulated profits
3. Calculation of new ratio, sacrificing ratio and gaining ratio
4. Treatment of goodwill
5. Readjustment of capital accounts
Assets and liabilities are often shown in the accounts at their historical value rather than realisable value. Due to conservatism the partners usually do not revise the values of assets even when their actual market values are much higher than book values. Similarly inadequate depreciation, change in technology etc. make the book values of certain assets more than their realisable value. It is not practical for the partners to keep on changing the book values of their assets every time there is a change in their market values. The difference between book value and market value is not a problem as long as the partnership business goes on normally. But when they change the structure of the partnership in the form of revision in profit sharing ratio, admission of a new partner, retirement or death of a partner, amalgamation of two partnership firms or absorption of a firm by another, the values of assets and liabilities are to be reassessed and difference if any, should be accounted.
What is the purpose of revaluation?
When the realisable value of asset or liability is different from the book value there is a profit or loss hidden in the difference in value. The partners should distribute all the profits and losses in the existing profit sharing ratio before changing the ratio. If the ratio remains unchanged there is practically no use in estimating the hidden profit or loss. However, if this profit or loss is not distributed prior to changing profit sharing ratio some partners will lose and others gain due to the change in ratio.
For example: A&B, who were equal partners purchased land for Rs.10,000 in Jan 1975. They decided to share profits and losses in the ratio 2:1 from 1st January 2001. The actual market value of land on 1st January was Rs.70,000; whereas the book value remains at the purchase price of Rs.10,000. There is a hidden profit of Rs.60,000 in the value of land which A & B are entitled to share equally. Suppose they just ignored this factor and changed the profit sharing ratio to 2:1 and sold the land for Rs.70,000 next day, the profit on sale of land Rs.60,000 will go to A and B in the new ratio 2:1, which means A will get 40,000 and B will get only 20,000. In other words Rs.10,000 belonging to B will go to A. Vice versa can happen in case of a hidden loss. To prevent such problems the partners revalue the assets and liabilities and transfer the profit or loss into their capital accounts in the existing ratio before making a change.
When the value of one asset is to be increased in the books it can be easily done by debiting the asset and crediting the profit to partners’ capital accounts in the profit sharing ratio. But when there is a major shake up, values of almost every asset and liability have to be revised. Distributing each change to the partners would be a lengthily process. For the sake of convenience, all those profits and losses on change in values of assets and liabilities are brought into a temporary account called ‘revaluation account’. The revaluation account summarises the effect of revaluation of assets and liabilities.
Revaluation account is a special profit & loss account representing the combined capital accounts of partners. Any gain on revaluation of asset or liability, to be credited to partners, will be credited in the revaluation account. Similarly any loss on revaluation will be debited in revaluation account instead of debiting the capital accounts. The final balance in revaluation account indicates the profit or loss on the entire revaluation process. The revaluation account is closed by transferring this profit or loss to partner’s capital accounts in the ratio before revision (old profit sharing ratio). All assets and liabilities will appear at their revised values in the books and in all future balance sheets.
When the partners want to adjust the profit or loss on revaluation process without actually changing the values of assets and liabilities in the books they can do so by opening a memorandum revaluation account. This revaluation account has two parts. The first part is a normal revaluation account and the profit or loss on this part is transferred in the old profit sharing ratio. The second part of memorandum revaluation account is almost a mirror image of the first part. Whatever debited in the first section is credited in the second and whatever credited is debited. Naturally if there was profit in the first section, there will be loss in the second and vice versa. The profit or loss in the first part is transferred to capital accounts in the old ratio, and that at the second part will be transferred to capital accounts new profit sharing ratio. As a result of this exercise the effect of profit or loss on revaluation will be fairly embedded in the capital accounts of partners.
Distribution of reserves and accumulated profits is the first step in any reorganisation process. They include general reserves, credit balance in P & L accounts or any other fund that are retained in the business. These are profits earned in the past, but not taken out by the partners, or profits kept aside. Therefore, when the partners decide to change their future profit sharing ratio, the past profits retained in the above accounts should be distributed to partners in the old ratio as a first step.nted pE � o b 0#d ssion of a new partner. There are basically three methods of treatment of goodwill on admission, which are:
Memorandum revaluation method
Under premium method the new partner pays cash for his share goodwill along with his capital. Cash account is debited for both these payments. The total amount brought in by the new partner (Capital + Goodwill) is credited to his capital account. The goodwill part of this payment belongs to the old partners. This amount is transferred to their capital accounts IN THE SACRIFICING RATIO. Since goodwill account is not opened in the book of the firm it will not appear in the balance sheet.
If there is any goodwill partly appearing in the balance sheet of the firm and the new partner is willing to contribute for his share, there are two options available for its treatment.
First, the existing goodwill may be left intact, and collect the new partner’s share of the remaining value of goodwill only.
Alternatively, write off the existing goodwill against the capital accounts of old partners in their old profit sharing ratio and collect the share for full value of goodwill from the new partner.
This method is practically a variation of premium method. Here the new partner does not bring in money specifically for his share of goodwill. The best option in this situation is to raise goodwill. For unreasonable reasons, raising goodwill is not allowed. The last resort is margin adjustment. Here the goodwill is adjusted only through the capital accounts. This method will work fine for all cases of reconstitution. When profit sharing ratio is changed at reconstruction something is added or deducted from their old profit share. In other words the partners retain a major part of their old profit share for which no adjustment is required. Goodwill under this method is adjusted on the basis of marginal increase or decrease of profit share. The basic rule is that the gaining partner shall compensate the sacrificing partner.
Following are the steps involved in goodwill adjustment.
i) Find out the partner’s sacrifice / gain
ii) Debit gaining partner and credit the sacrificing partner with the proportionate value of goodwill.
If you find the ratios bit difficult, you can arrive at the margin values by following memorandum revaluation in a different format in the workings. This is basically crediting full value of goodwill to partners’ capital accounts in the old ratio and debiting it in the new ratio. The net result is premium being adjusted in the account. You are not allowed to show these entries in the capital account. But the examiner has no problem if you do it in the workings.