Chapter 2 — Reconstitution of a Partnership Firm — Admission of a Partner

Chapter 2 covers reconstitution of a partnership firm through admission of a new partner. It explains new and sacrificing profit-sharing ratios, valuation and treatment of goodwill, revaluation of assets and liabilities, adjustment for accumulated profits and reserves, and capital adjustment of partners.

Reconstitution means any change in the existing partnership agreement that ends the old agreement and brings a new one into force while the firm continues. It can occur through admission of a new partner, change in profit-sharing ratio, retirement, death, or insolvency of a partner.

According to the Partnership Act 1932, a new partner can be admitted only with the unanimous consent of all existing partners, unless the partnership deed provides otherwise. The new partner then acquires the right to share the assets and profits of the firm.

The sacrificing ratio is the ratio in which old partners agree to give up their share of profit in favour of the incoming partner. It is calculated by deducting each old partner's new share from their old share. The premium for goodwill brought by the new partner is distributed among old partners in this ratio.

Goodwill is the monetary value of a firm's reputation, good name, and business connections that enables it to earn more profits than a newly set up business. It is defined as the present value of a firm's anticipated excess earnings. Goodwill exists only when the firm earns super profits; a firm earning only normal profits or incurring losses has no goodwill.

The three methods are: (1) Average Profits Method — goodwill equals average profits (simple or weighted) multiplied by an agreed number of years' purchase; (2) Super Profits Method — super profit (average profit minus normal profit) multiplied by years' purchase; (3) Capitalisation Method — either capitalise average profits and deduct net assets, or directly capitalise super profits by multiplying by 100 divided by the normal rate of return.

Under the super profits method, normal profit is first calculated as firm's capital multiplied by the normal rate of return divided by 100. Super profit is the excess of average profit over normal profit. Goodwill equals super profit multiplied by the agreed number of years' purchase.

Hidden goodwill arises when the goodwill value is not stated but can be inferred from the new partner's capital contribution and profit share. The total capital implied by the new partner's capital and share is compared with the actual combined capital of all partners; the difference is the firm's total goodwill, from which the new partner's share is determined.

When goodwill already appears in the books at the time of admission, it is written off by debiting the old partners' capital accounts in their old profit-sharing ratio and crediting the Goodwill Account. After writing it off, the new value of goodwill is then given effect through the usual goodwill adjustment entries.

The Revaluation Account records all changes in asset values and liabilities at the time of admission. Increases in asset values and decreases in liabilities are credited (gain); decreases in asset values, increases in liabilities, and unrecorded liabilities are debited (loss). The resulting net balance — profit or loss — is transferred to the old partners' capital accounts in their old profit-sharing ratio.

Accumulated profits, general reserves, and credit balances in the Profit and Loss Account existing before admission belong to the old partners. They are transferred to the old partners' capital or current accounts in the old profit-sharing ratio. Accumulated losses and debit balances are similarly debited to old partners in the old ratio.

If agreed, capitals are made proportionate to the new profit-sharing ratio. The new partner's capital is used as a base to determine required capitals for old partners. A partner with surplus capital withdraws the excess amount and a partner with a shortfall brings in the deficiency; alternatively, differences are transferred to current accounts.

If the new partner does not bring the goodwill premium in cash, the new partner's Current Account is debited for the amount not brought, and the sacrificing partners' Capital Accounts are credited in their sacrificing ratio. If goodwill already exists in the books, it is first written off in the old ratio before crediting the sacrificing partners.

The main factors are: nature of business (high value-added or stable demand products earn more), location (central or high-traffic location), efficiency of management (high productivity and cost efficiency), market situation (monopoly or limited competition), and special advantages such as import licences, assured power supply, long-term contracts, patents, and trademarks.

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