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A partnership business may
undergo several structural changes during its lifetime. New
partners may join or existing ones may leave the business. While
making such major changes in the structure of business, partners
carefully evaluate their accounts. They have to reset the system
on a correct starting point. They check the values of assets and
liabilities appearing in the books. If there are discrepancies
they have to be rectified before introducing a major change.
Reconstitution of a partnership business can take place under
the following situations:
-
Admission of a new
partner
-
Changing profit
sharing ratio among existing partners
-
Retirement / death of
a partner
-
Amalgamation of two
partnership firms
The most important
accounting adjustment is resetting of old accounts. It is a
common adjustment in all cases of reconstitution. In this
chapter you will find reconstitution by admission and
reconstitution by changing ratios. Reconstitution by admission
is more important on examination point of view. The following
are the common adjustments at the time of reconstitution of a
partnership business.
1. Revaluation of assets
and liabilities
2. Distribution of
reserves and accumulated profits
3. Calculation of new
ratio, sacrificing ratio and gaining ratio
4. Treatment of goodwill
5. Readjustment of capital
accounts
1. Revaluation of Assets and
Liabilities
Assets and liabilities are
often shown in the accounts at their historical value rather
than realisable value. Due to conservatism the partners usually
do not revise the values of assets even when their actual market
values are much higher than book values. Similarly inadequate
depreciation, change in technology etc. make the book values of
certain assets more than their realisable value. It is not
practical for the partners to keep on changing the book values
of their assets every time there is a change in their market
values. The difference between book value and market value is
not a problem as long as the partnership business goes on
normally. But when they change the structure of the partnership
in the form of revision in profit sharing ratio, admission of a
new partner, retirement or death of a partner, amalgamation of
two partnership firms or absorption of a firm by another, the
values of assets and liabilities are to be reassessed and
difference if any, should be accounted.
What is the purpose
of revaluation?
When the realisable value
of asset or liability is different from the book value there is
a profit or loss hidden in the difference in value. The partners
should distribute all the profits and losses in the existing
profit sharing ratio before changing the ratio. If the ratio
remains unchanged there is practically no use in estimating the
hidden profit or loss. However, if this profit or loss is not
distributed prior to changing profit sharing ratio some partners
will lose and others gain due to the change in ratio.
For example: A&B, who were
equal partners purchased land for Rs.10,000 in Jan 1975. They
decided to share profits and losses in the ratio 2:1 from 1st
January 2001. The actual market value of land on 1st
January was Rs.70,000; whereas the book value remains at the
purchase price of Rs.10,000. There is a hidden profit of
Rs.60,000 in the value of land which A & B are entitled to share
equally. Suppose they just ignored this factor and changed the
profit sharing ratio to 2:1 and sold the land for Rs.70,000 next
day, the profit on sale of land Rs.60,000 will go to A and B in
the new ratio 2:1, which means A will get 40,000 and B will get
only 20,000. In other words Rs.10,000 belonging to B will go to
A. Vice versa can happen in case of a hidden loss. To prevent
such problems the partners revalue the assets and liabilities
and transfer the profit or loss into their capital accounts in
the existing ratio before making a change.
Revaluation Account
When the value of one
asset is to be increased in the books it can be easily done by
debiting the asset and crediting the profit to partners’ capital
accounts in the profit sharing ratio. But when there is a major
shake up, values of almost every asset and liability have to be
revised. Distributing each change to the partners would be a
lengthily process. For the sake of convenience, all those
profits and losses on change in values of assets and liabilities
are brought into a temporary account called ‘revaluation
account’. The revaluation account summarises the effect of
revaluation of assets and liabilities.
Revaluation account is a
special profit & loss account representing the combined capital
accounts of partners. Any gain on revaluation of asset or
liability, to be credited to partners, will be credited in the
revaluation account. Similarly any loss on revaluation will be
debited in revaluation account instead of debiting the capital
accounts. The final balance in revaluation account indicates the
profit or loss on the entire revaluation process. The
revaluation account is closed by transferring this profit or
loss to partner’s capital accounts in the ratio before revision
(old profit sharing ratio). All assets and liabilities will
appear at their revised values in the books and in all future
balance sheets.
When the partners want to
adjust the profit or loss on revaluation process without
actually changing the values of assets and liabilities in the
books they can do so by opening a memorandum revaluation
account. This revaluation account has two parts. The first
part is a normal revaluation account and the profit or loss on
this part is transferred in the old profit sharing ratio. The
second part of memorandum revaluation account is almost a mirror
image of the first part. Whatever debited in the first section
is credited in the second and whatever credited is debited.
Naturally if there was profit in the first section, there will
be loss in the second and vice versa. The profit or loss in the
first part is transferred to capital accounts in the old ratio,
and that at the second part will be transferred to capital
accounts new profit sharing ratio. As a result of this exercise
the effect of profit or loss on revaluation will be fairly
embedded in the capital accounts of partners.
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