Reconstitution of a Partnership Firm – Retirement/Death of a Partner Explained

Understanding Reconstitution of a Partnership Firm

Reconstitution of a partnership firm refers to any change in the existing partnership agreement except the dissolution of the firm. In Class 12 NCERT Accountancy, this topic covers scenarios like retirement or death of a partner, admission of a new partner, or change in profit-sharing ratio.

When a partner retires or dies, the firm continues but the internal structure changes. This requires:

• Revaluation of assets and liabilities
• Adjustment of goodwill
• Revision of capital accounts
• Redistribution of profits and reserves

The main goal is to update the financial position and profit-sharing pattern to reflect the new partnership arrangement fairly.

Revaluation of Assets and Liabilities on Retirement or Death

At the time of retirement or death of a partner, the firm must ascertain the true value of assets and liabilities. This process is called revaluation or reassessment.

Why revaluation is important:

• Assets may appreciate or depreciate over time
• Liabilities may increase or decrease
• Unrecorded assets or liabilities may come to light

Accounting treatment:

• Increase in assets: Debit Asset Account, Credit Revaluation Account
• Decrease in assets: Debit Revaluation Account, Credit Asset Account
• Increase in liabilities: Debit Revaluation Account, Credit Liability Account
• Decrease in liabilities: Debit Liability Account, Credit Revaluation Account
• Unrecorded asset: Debit Asset Account, Credit Revaluation Account
• Unrecorded liability: Debit Revaluation Account, Credit Liability Account

If the revaluation results in a profit, it is credited to partners’ capital accounts in their old profit-sharing ratio. If it results in a loss, it is debited similarly.

Example:

This ensures fairness before settling accounts with the retiring or deceased partner.

Adjusting Goodwill on Retirement or Death of a Partner

Goodwill represents the firm's reputation and earning capacity, an intangible asset shared among partners. When a partner retires or dies, their share of goodwill must be compensated by the continuing partners.

Key points:

• Goodwill is valued based on agreed methods (e.g., average profit method)
• The retiring partner’s share of goodwill is paid by continuing partners in their gaining ratio

Gaining ratio:

It is the ratio in which continuing partners gain the retiring partner’s share. Calculated as:

$$\text{Gaining Ratio} = \text{New Share} - \text{Old Share}$$

Example:

If a continuing partner’s old share was $\frac{1}{5}$ and new share is $\frac{3}{10}$:

$$\text{Gaining Ratio} = \frac{3}{10} - \frac{1}{5} = \frac{3}{10} - \frac{2}{10} = \frac{1}{10}$$

Journal entry for goodwill adjustment:

• Continuing partners’ capital accounts Dr.
• To Retiring partner’s capital account

This adjustment ensures the retiring partner receives fair compensation for their goodwill share.

Distribution of Reserves and Accumulated Profits

Before the retiring or deceased partner’s capital account is settled, all reserves and accumulated profits must be distributed among partners in the old profit-sharing ratio.

Types of reserves:

• General Reserve
• Profit & Loss Suspense Account
• Other accumulated profits

Purpose:

• To ensure the retiring partner receives their rightful share of reserves
• To update capital accounts accurately

Example journal entry:

This entry transfers the general reserve to partners’ capital accounts in the old ratio before retirement settlement.

Settlement of Retiring or Deceased Partner’s Capital Account

After revaluation, goodwill adjustment, and reserve distribution, the retiring or deceased partner’s capital account is settled.

Settlement modes:

• Payment in cash or bank
• Transfer of assets/liabilities
• Adjustment through loan account (if payment is deferred)

Important considerations:

• The amount payable includes capital, share of revaluation profit/loss, share of goodwill, and reserves
• If the partner dies, the amount is paid to their legal heirs

Example journal entry for payment:

• Retiring Partner’s Capital A/c Dr.
• To Cash/Bank A/c

This completes the reconstitution process ensuring smooth continuation of the firm.

Summary Table: Key Accounting Entries on Retirement/Death