Structural changes in partnership


Partnership is an agreement between two or more partners for sharing the profits of a business carried on by all or any of them acting for all. Any change in the existing agreement requires a reconstitution of the partnership firm. This results in the end of the existing agreement and a start of new agreement. The partners often resort to reconstitution of the firm in various ways such as:

  • Admission of a new partner

A new partner may be admitted when the firm needs additional capital, to take advantage of the experience and competence of the newly admitted partner and for managerial help.

  • Retirement, death or insolvency of a partner

Retirement simply means withdrawal of a partner from the business due to bad health, old age or change in business interests. Partnership may also stand reconstituted on death/insolvency of a partner, if the remaining partners decide to continue the business of the firm as usual.

  • Change in profit sharing ratio

Sometimes the partners of a firm may decide to adjust their existing profit sharing ratio if there is a change in existing partners’ role and responsibility in the firm.

Whatever be the reason for the structural change in the partnership, the following must be considered:

  • Accounting for Goodwill
  • Revaluation of Assets and Liabilities

Accounting for Goodwill

Goodwill is the value of the reputation of a firm built over time with respect to the expected future profits over and above the normal profits. A well-established firm earns a good name in the market, builds trust with the customers and also has more business connections as compared to a newly set up business. Thus, the monetary value of this advantage that a buyer is ready to pay is termed as Goodwill. It is regarded as an intangible asset.

There is no exhaustive list of factors affecting goodwill. The following factors, however, commonly affect a firm’s goodwill:

  • Partners’ ability to attract customers due to their reputation
  • Quality of goods or services
  • Customer satisfaction
  • Location of business

Accounting Treatment

  • Goodwill is created (Using partner’s old profit sharing ratio)

Debit               Goodwill Account

Credit              Partner’s Capital Account

In case Goodwill is not to be retained in the partnership books. Then Goodwill must be written off.

  • Goodwill is written off (Using Partner’s new profit sharing ratio)

Debit               Partner’s Capital Account

Credit              Goodwill Account

Revaluation of Assets and Liabilities

The assets are re-valued and liabilities are reassessed so that:

  • Assets are not overstated or understated.
  • Liabilities are brought in the books at their correct values
  • Unrecorded assets and liabilities of the firm are recorded into the books of the firm
  • The actual position of the firm is shown.

For this purpose, a Revaluation Account is prepared. Increase in assets and decrease in liabilities are credited because it is a gain. Decrease in the value of assets and increase in liabilities are debited because it is a loss. If the account finally shows a credit balance then it indicates Profit on Revaluation and if there is a debit balance then it indicates Loss on Revaluation. Profit or loss must be transferred to the capital accounts of the old partners in old profit and loss sharing ratio.


Revaluation Account


$


$

Decrease in Non current assets

***

Increase in Non current assets

***

Decrease in Inventory

***

Increase in Inventory

***

Decrease in Trade receivables

***

Increase in Trade receivables

***

Increase in Trade payables

***

Decrease in Trade payables

***

*Profit on Revaluation


*Loss on Revaluation


Partner A

***

Partner A

***

Partner B

***

Partner B

***


***


***


Note:

  • Entries in Revaluation account is made only by the amount increase or decrease in assets and liabilities.
  • Profit / Loss on Revaluation are based on partner’s old profit sharing ratio.

Main Journal Entries

  • Increase in assets

Debit               Assets account

Credit              Revaluation account

  • Decrease in assets

Debit               Revaluation account

Credit              Assets account

  • Increase in liabilities

Debit               Revaluation account

Credit              Liabilities account

  • Decrease in liabilities

Debit               Liabilities account

Credit              Revaluation account

  • Profit on Revaluation

Debit               Revaluation account

Credit              Partner’s capital account

  • Loss on Revaluation 

Debit               Partner’s capital account

Credit              Revaluation account

  • Goodwill created (old ratio)

Debit               Goodwill account

Credit              Capital account

  • Goodwill written off (new ratio)

Debit               Capital account

Credit              Goodwill account

  • Cash / Assets brought in by new partner

Debit               Cash / Assets account

Credit              Partner’s capital account

  • Payment to retiring partner / Balance kept as loan

Debit               Capital account

Credit              Cash / Loan account

  • Assets taken by retiring partner

Debit                Capital account

Credit               Assets account


Worked Example 1 – Admission of partner

James and Lewis have been in partnership for some years sharing profits and losses equally. They had no partnership agreement. Their statement of financial position at 30 September 2015 showed the following information.

Statement of financial position as at 30th September 2015




$

Non-current assets



230 000

Net current assets



60 000




290 000

Capital Accounts




James



200 000

Lewis



70 000

Current Accounts

James

Lewis


 

$

$


Opening balance

31 000

17 000


Share of profit

15 000

15 000


Drawings

(21 000)

(37 000)


Closing balance

25 000

(5 000)

20 000




290 000


Additional information


On 1 October 2015 Ahmed joined the partnership. A partnership agreement was drawn up. The terms set out in the agreement were:

  1. Profits and losses are to be shared equally.
  2. Interest is to be charged at 5% on drawings.
  3. Interest is to be allowed at 10% on capital.

The following also took place:

  1. Ahmed introduced capital of $80 000, which he paid into the business bank account.
  2. Goodwill was valued at $60 000 but no goodwill account is to be maintained in the books of account.
  3. Non-current assets were revalued at $270 000.
  4. The inventory value was to be reduced by $4000.

Required : Redraft the Statement of financial position as at 1st October 2015

Step 1 – Calculation of Goodwill

Goodwill Created

Goodwill w/o (Written off)

Old Profit Sharing Ratio = 1:1

New Profit Sharing Ratio 1:1:1

James = 1 / 2 * 60 000 = $ 30 000

James = 1 / 3 * 60 000 = $ 20 000

Lewis = 1 / 2 * 60 000 = $ 30 000

Lewis = 1 / 3 * 60 000 = $ 20 000


Ahmed = 1 / 3 * 60 000 = $ 20 000


Step 2 – Revaluation Account

DR                                                                                            Revaluation Account                                                                                             CR

 

$

 

$

Inventory

4 000

Non current assets (270 000-230 000)

40 000

Profit on Revaluation – Old Ratio




James = 1 / 2 * 36 000

18 000



Lewis = 1 / 2 * 36 000

18 000




40 000


40 000


Step 3 – Capital Account

DR                                                                              Capital Accounts                                                                              CR

 

James

Lewis

Ahmed

 

James

Lewis

Ahmed

 

$

$

$

 

$

$

$

Goodwill w/o

20 000

20 000

20 000

Balance b/f

200 000

70 000


Balance c/d

228 000

98 000

60 000

Goodwill created

30 000

30 000






Bank



80 000





Profit on revaluation

18 000

18 000



248 000

118 000

80 000


248 000

118 000

80 000





Balance b/d

228 000

98 000

60 000


Statement of financial position as at 1st October 2015

$

Non-current assets

270 000

Net current assets (60 000 – 4 000 + 80 000)

136 000


406 000

Capital Accounts


James

228 000

Lewis

98 000

Ahmed

60 000

Current Accounts


James

25 000

Lewis

(5000)


406 000


Worked Example 2 – Retirement of partner

Alex, Barn and Chuck are partners sharing profits and losses in the ratio 2:2:1 respectively. Their statement of financial position as at 31st December 2016 was as follows:

Statement of financial position as at 31st December 2016

Non current assets

$

$

Machinery


60 000

Equipment


15 000



75 000

Current assets



Closing inventory

13 500


Trade receivables

23 500


Bank

43 000

80 000



155 000

Capital Account



Alex


40 000

Barn


40 000

Chuck


20 000

Current Account



Alex


1 500

Barn


2 400

Chuck


2 600



106 500

Non current liabilities



Loan


30 000

Current liabilities



Trade payables


18 500

 

 

155 000


On 1st January 2017 Alex decided to retire from the business and the following terms were agreed:

  • Barn and chuck to continue the partnership business and will share profits and losses in the ratio 3:2
  • Goodwill valued at $60 000 was not to be maintained in the books.
  • Alex were to take one of the equipment at an agreed value of $ 4 000. The remaining motor vehicles were revalued at $ 9 000.
  • The following assets were revalued:

Machinery                   80 000                        

Inventory                     13 000

Trade receivables       22 000

  • Amount owed to Alex was left in the business as a loan.

Required – Redraft the Statement of financial position as at 1st January 2017

Step 1 – Calculation of Goodwill

Goodwill Created

Goodwill w/o (Written off)

Old Profit Sharing Ratio = 2:2:1

New Profit Sharing Ratio 3:2

Alex = 2/5*60 000 = $ 24 000

Barn = 3/5*60 000 = $ 36 000

Barn = 2/5*60 000 = $ 24 000

Chuck = = 2/5*60 000 = $ 24 000

Chuck = 1/5*60 000 = $ 12 000



Step 2 – Revaluation Account

DR                                                                                               Revaluation Account                                                                                               CR

 

$

 

$

Equipment (15 000 – 4 000 – 9 000)

2 000

Machinery (80 000 – 60 000)

20 000

Inventory (13 500 – 13 000)

500



Trade receivables (23 500 – 22 000)

1 500



Profit on Revaluation – Old Ratio




Alex = 2/5*16 000

6 400



Barn= 2/5*16 000

6 400



Chuck= 1/5*16 000

3 200




20 000


20 000


Step 3 – Capital Account

DR                                                                                      Capital Accounts                                                                                      CR

 

Alex

Barn

Chuck

 

Alex

Barn

Chuck

 

$

$

$

 

$

$

$

Goodwill w/o


36 000

24 000

Balance b/f

40 000

40 000

20 000

Equipment

4 000



Current Account

1 500



Loan

67 900



Goodwill created

24 000

24 000

12 000





Profit on revaluation

6 400

6 400

3 200

Balance c/d


34 400

11 200






71 900

70 400

35 200


71 900

70 400

35 200





Balance b/d


34 400

11 200


Statement of financial position as at 1st January 2017

Non current assets

$

$

Machinery


80 000

Equipment


9 000



89 000

Current assets



Closing inventory

13 000


Trade receivables

22 000


Bank

43 000

78 000



167 000

Capital Account



Barn


34 400

Chuck


11 200



45 600

Current Account



Barn


2 400

Chuck


2 600



50 600

Non current liabilities



Loan (30 000 + 67 900)


97 900

Current liabilities



Trade payables


18 500

 

 

167 000


Worked Example 3 - Change in Partnership agreement

Poppy and Rose have been in partnership for some years. On 31 December 2009 their statement of financial position showed the following:




$

Capital accounts

Poppy

150 000


Rose

90 000

Current accounts

Poppy

8 500


Rose

(2 100)


Poppy and Rose shared profits equally and received annual salaries of $10 000 and $4000 respectively until 30 June 2010. Interest on capital was calculated at 10%.

On 1 July 2010 a new partnership agreement came into force which stated that:

  1. Poppy and Rose would share profits in the ratio 3:2
  2. receive annual salaries of $24 000 and $18 000 respectively
  3. the rate of interest on capital to remain unchanged
  4. goodwill had a value of $25 000 but it was not to be retained in the books
  5. premises should be revalued upwards by $70 000.

At the end of the year a trainee accountant produced their year end accounts. He forgot to take into account that the partnership agreement had been changed. He produced a draft set of accounts which showed that the following on 31 December 2010:


Drawings during the year had been:

Poppy

Rose


$

$

6 months ended 30 June

9 000

7 500

6 months ended 31 December

12 000

11 000


Interest on drawings for the year was calculated as:



Poppy

Rose


$

$

6 months ended 30 June

820

720

6 months ended 31 December

1 700

1 500


Profits of $ 66 000 (accrued evenly across the year)


Step 1 – Goodwill


Goodwill Created

Goodwill written off

Old profit sharing ratio (1:1)

New profit sharing ratio (3:2)

Poppy = 1 / 2 * 25 000 = 12 500

Poppy = 3 / 5 * 25 000 = 15 000

Rose = 1 / 2 * 25 000 = 12 500

Rose = 2 / 5 * 25 000 = 10 000


Step 2 – Revaluation Account


Revaluation Account


$


$

Profit on Revaluation (1:1)


Premises

70 000

Poppy

35 000



Rose

35 000




70 000


70 000


Step 3 – Capital Account


DR                                                                     Capital Account                                                                     CR


Poppy

Rose


Poppy

Rose


$

$


$

$

Goodwill w/o

15 000

10 000

Balance b/f

150 000

90 000

Balance c/d

182 500

127 500

Profit on revaluation

35 000

35 000




Goodwill

12 500

12 500


197 500

137 500


197 500

137 500




Balance b/d

182 500

127 500


Step 4 – Appropriation Account


Appropriation account for the

6 months to 30th June 2010

6 months to 31st Dec. 2010


$

$

$

$

Profit for the year (6/12 * 66 000)


33 000


33 000

Add interest on drawings





Poppy


820


1 700

Rose


720


1 500



34 540


36 200

Less appropriations





Interest on capital





Poppy

10/100 * 150 000 * 6/12

10/100 * 182 500 * 6/12

7 500


9 125


Rose

10/100 * 90 000 * 6/12

10/100 * 127 500 * 6/12

4 500


6 375


Salaries





Poppy

6/12 * 10 000

6/12 * 24 000

5 000


12 000


Rose

6/12 * 4 000

6/12 * 18 000

2 000

19 000

9 000

36 500

Residual profit / (loss)


15 540


(300)

Share of profit / (loss)





Poppy

1 / 2 * 15 540

3 / 5 * 300


7 770


(180)

Rose

1 / 2 * 15 540

2 / 5 * 300


7 770


(120)



15 540


(300)


Step 5 – Current Account


DR                                                                   Current Account                                                                     CR


Poppy

Rose


Poppy

Rose


$

$


$

$

Balance b/f


2 100

Balance b/f

8 500


Drawings

21 000

18 500

Interest on capital

16 625

10 875

Interest on drawings

2 520

2 220

Salary

17 000

11 000

Balance c/d

26 195

6 705

Share of profit

7 590

7 650


49 715

29 525


49 715

29 525




Balance b/d

26 195

6 705