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.

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

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

Step 2 – Revaluation Account

Step 3 – Capital Account

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 31^st December 2016 was as follows:

On 1^st 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 1^st January 2017

Step 1 – Calculation of Goodwill

Step 2 – Revaluation Account

Step 3 – Capital Account

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:

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:

Interest on drawings for the year was calculated as:

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

Step 1 – Goodwill

Step 2 – Revaluation Account

Step 3 – Capital Account

Step 4 – Appropriation Account

Step 5 – Current Account