Chapter 3 — Reconstitution of a Partnership Firm — Retirement/Death of a Partner

Chapter 3 covers reconstitution of a partnership firm on retirement or death of a partner. Topics include calculating the new profit sharing ratio and gaining ratio, treatment of goodwill, revaluation of assets and liabilities, adjustment of accumulated profits and losses, and the modes of settling the amount due to the retiring partner or the deceased partner's executors.

New profit sharing ratio is the ratio in which the remaining partners share future profits after the retirement or death of any partner. The new share of each continuing partner equals his old share plus the share acquired from the retiring or deceased partner.

Gaining ratio is the ratio in which the continuing partners have acquired the share from the retiring or deceased partner. When the new profit sharing ratio is specified, Gaining Share = New Share minus Old Share for each continuing partner.

In the absence of any information, it is assumed that the continuing partners acquire the retiring or deceased partner's share in their old profit sharing ratio, and so the new profit sharing ratio is the same as the old ratio among the continuing partners.

The retiring or deceased partner is credited for his share of goodwill in his capital account, and the continuing partners who have gained are debited in their gaining ratio. If goodwill already appears in the books, it is first written off by debiting all partners' capital accounts in the old profit sharing ratio before the retiring partner's share of the current value of goodwill is adjusted.

When a lump sum is agreed to be paid to the retiring partner and this amount exceeds the balance in his capital account after all adjustments for reserves and revaluation, the excess is treated as his share of goodwill, called hidden goodwill. This is debited to the continuing partners' capital accounts in their gaining ratio and credited to the retiring partner's capital account.

At the time of retirement or death, some assets may not be shown at their current values and some liabilities may differ from the actual obligation. A Revaluation Account is prepared to ascertain the net gain or loss on revaluation and to bring unrecorded assets and liabilities into the books; the profit or loss is then transferred to all partners, including the retiring or deceased partner, in their old profit sharing ratio.

Accumulated profits such as general reserves are transferred to the capital accounts of all partners, including the retiring or deceased partner, in their old profit sharing ratio. Accumulated losses are similarly charged to all partners in the old profit sharing ratio.

The retiring partner may be paid the full amount in cash immediately; if the firm cannot pay at once, the amount is transferred to a Retiring Partner's Loan Account and repaid in instalments with interest; or a part may be paid in cash and the rest treated as a loan. In the absence of an agreement, Section 37 of the Indian Partnership Act, 1932 entitles the outgoing partner to interest at 6% per annum or a share of profits earned with his money.

When a partner retires during the year, his share of profit for the intervening period is calculated on the basis of the previous year's profit, the average of past few years' profits, or the sales during the period. A Profit and Loss Suspense Account is used to record the amount credited to the retiring partner, and it is later closed by debiting the gaining partners in their gaining ratio.

The accounting treatment is largely similar, but on death the amount due is transferred to the Executor's Account instead of being settled directly with the partner. Additionally, while retirement usually occurs at the end of an accounting period, death can occur at any time, making it necessary to calculate the deceased partner's share of profit for the intervening period from the last balance sheet to the date of death.

When a partner dies, the total amount due to the deceased partner, comprising the capital balance, share of goodwill, share of accumulated profits, and share of profit up to the date of death, is transferred from his capital account to the Executor's Account. The legal representative or executor is then paid from this account in the agreed manner.

After retirement, the continuing partners may decide to adjust their capitals in their new profit sharing ratio. The total of the continuing partners' capital balances after all adjustments is taken as the total capital of the new firm, divided in the new profit sharing ratio, and each partner brings in cash or withdraws the excess as required.

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