Adjustments Required on the Admission of a Partner
The adjustments required on admission of partner are:
- Determining new profit sharing ratio
- Goodwill
- Adjustment of profit/loss arising from revaluation of assets and reassessment of liabilities
- Adjustment of accumulated profits reserves and losses
- Adjustment of capital (if agreed)
Calculation of New Profit Sharing Ratio and Sacrificing Ratio : New or incoming partner is entitled to share future profits of the firm. In effect there is a change in the old profit sharing ratio.
Since, new or incoming partner acquires his share from old partners, therefore, it is necessary to determine new profit sharing ratio and also sacrificing ratio.
New Profit Sharing Ratio : New profit sharing ratio is the ratio in which all partners including new or incoming partner share future profits and losses of the firm.
Sacrifice Ratio: Whenever there is an admission of a new partner, old partners have to surrender some of their old shares in favor of the new partner. The ratio in which they surrender their profits is called Sacrifice Ratio. Goodwill is paid to the old partners in their sacrifice ratio because the goodwill is the amount of compensation to be paid by the new partner to the old partner for acquiring the share of profits which they have surrendered in favor of the new partner.
Calculation : Sacrifice Ratio = Old Ratio – New Ratio
Goodwill: Goodwill is nothing more then the probability that the old customers will resort to the old place. Goodwill is the present value of a firm anticipated excess earnings. It is attributable to the reputation which is acquired by an undertaking operating successfully.
Revaluation of Assets and Reassessment of Liabilities: Whenever a new partner is admitted, it becomes necessary to revalue the assets and liabilities of the firm to their true and fair values. This is done because with the passage of time, the value of certain assets might have increased, while the value of certain other assets might have decreased. Thus, the actual value of various assets and liabilities may be different from the values stated in the balance sheet. New partner should not suffer because of reduction in the value of assets nor should he be benefited by increase in the value of assets. Thus, the entire profit or loss arising from revaluation is divided between the old partners in their old profit sharing ratio.
Revaluation of assets and liabilities is done with the help of a new account called “Revaluation Account’’. Sometimes, this account is called as “Profit and Loss Adjustment Account”. This account is a nominal account in nature. Therefore, if there is a loss due to revaluation, revaluation account is debited and if the revaluation results in a profit, the revaluation account is credited.
Accounting Treatment of Reserves and Accumulated Profits or Losses : At the time of admission, if there is any general reserve, reserve fund or the balance of profit and loss account appearing in the balance sheet, it must be transferred to old partners’ capital account in their old profit sharing ratio. The new partner is not entitled to any share of such reserves or profits as these are undistributed profits earned by the old partners. For this purpose, the following journal entries are recorded
(i) For Distributing Reserves and Accumulated Profits:
General Reserve A/ c Dr.
Reserve Fund A/c Dr.
Profit and Loss A/c (Credit Balance) Dr.
To Old Partners’ Capital or Current A/c
(ii) For Distributing Accumulated Losses Among Old Partners in Old Ratio : If there is any balance of P&L account appearing on the assets side of the balance sheet, the capital account of old partners are debited from the amount of this loss. The entry will be:
Old Partners’ Capital or Current A/c Dr.
To Profit and Loss A/c (Debit Balance)
(iii) For Distributing Surplus of Specific Reserves : The firm may have created some specific reserves like “Workmen’s Compensation Reserve” or “Investment Fluctuation Reserve” to meet certain future obligations. At the time of admission of a new partner, such reserves may be in excess of actual obligations.
Such excess reserves will be transferred to capital account of old partners in old ratio. The entry will be
Workmen’s Compensation Reserve A/ c Dr.
Investment Fluctuation Reserve A/ c Dr.
To Old Partners’ Capital or Current A/c
Entries for transferring the reserves and accumulated profits or losses must be passed even if the question is silent on this point.
Employee’s provident fund or employee’s saving account appearing on the liabilities side of the balance sheet are not distributed among old partners as they are not reserves but are the outside liabilities payable by the firm.
Adjustment of Capital:
- Adjustment of capital of old partners on the basis of new partners’ capital.
- Adjustment of new partner’s capital on the basis of old partners’ adjusted capital.
1. Adjustment of Old Partners’ Capital on the Basis of Capital of New Partner:
- Calculate new profit sharing ratio of all partners.
- Find out total capital of the firm on the basis of new partners’ capital and his share of profit.
- Total capital.be divided in new profit sharing ratio.
- Excess capital of old partner, if any be withdrawn in cash deficiency be brought in cash or record the same as provided in the question.
2. Determination of Share of Capital of New Partner on the Basis of Capitals of Old Partners:
- Find out old partners’ capital balance after making all adjustments regarding revaluation of assets and liabilities, share of goodwill brought in by new partner distributing undistributed profit and losses etc.
- Thereafter, find out residual share of profit after new partner’s share.
- For exampl, 1- \(\frac{1}{4}\) = \(\frac{3}{4}\)
- share of old partners as per above example.
- Then, find out the total capital of the firm on the basis of combined adjusted capital of the old partners and their share of profit.
- New partners’ capital = Total capital of the firm x His share in profit
