Reconstitution of Partnership

Retirement / Death of Partners 1

Syllabus

Ø Retirement / Death of a Partner: Change in profit sharing ratio, accounting treatment of goodwill, revaluation of assets and liabilities, adjustment of accumulated profits (reserves) and capitals

A person becomes a partner at his own will, as a result of a voluntary agreement. It does not happen due to inheritance or any other external factor on which one has no control. Similarly a partner can retire from the firm at his will subject to reasonable restrictions.

From the accounting pint of view retirement or death of a partner have almost similar effect. Retirement is a planned exit of a partner, while death is an unplanned exit.

Retirement or death dissolves the partnership. This dissolution does not mean the winding up of the business. It happens only in the legal aspect, not in its physical aspect. The remaining partners will continue to run the firm in a reorganised form with a new agreement. As retirement is a planned event, it is mostly done at the end of a financial year. The partners prepare themselves to deal with the problems associated with retirement. Death comes unexpectedly. It can happen any time during a financial year. Exit of a partner can create a vacuum in management and a financial emergency. Accounting treatment for retirement and death are almost the same. Capital and current account balances, along with the share of accumulated profits funds etc. are to be settled. Settlement of claim from Life insurance policies also has to be done. In the event of death, calculation of the deceased partner’s share of profit for the period of his service during the year of death is an additional factor to be accounted.

The following are the common accounting aspects to be considered at the time of retirement or death of partners.

1. Change in profit sharing ratio

2. Treatment of goodwill

3. Revaluation of assets and liabilities

4. Accumulated profits; reserves; losses etc.

5. Adjustment of Joint Life Policy

6. Adjustment of capital

1. Change in profit sharing ratio

Retirement or death reduces the number of partners to share future profits or losses. Naturally the share of profit for the continuing partners will increase by the retirement or death of a partner. Recalculation of ratios is the first step in for further accounting procedures. Revision in ratio may be indicated in any of the following ways in a question:

a.       Old ratio is given and nothing is mentioned about the new arrangement after retirement.

This is practically the easiest way of presenting new profit sharing arrangement. The new ratio under this method is found out simply by canceling the outgoing partner’s share of profit assuming that the ratio between the continuing partners does not change. When this method is followed the outgoing partner’s share merges into the continuing partners share in their profit sharing ratio.

Example: A, B and C have been sharing profits and losses in the ratio 3:2:1. B has retired from the business. Find out new ratio between A & C.

Here B is retired and nothing is mentioned about the arrangement between A & C. The new ratio is found out by simply canceling the B’s share of profit.

New ratio = 3:1

Here B’s share of 2/3 of profit is merged in the shares of A and C in the ratio 3:1.

b.      The outgoing partner’s share is taken over by the continuing partners in a certain ratio.

A & B have been sharing profits and losses in the ratio 3:2:1. B retired from the firm. His share of profit is divided equally between A & C. Find out new ratio.

Here B’s share of 2/6 is shared between A & C equally. The new share of A is his old share of 3/6 + 1/6 from B. Thus his new share is 4/6. C’s new share is his old share of 1/6 + 1/6 from B. Thus his new share is 2/6. New profit sharing ratio is 4:2 that is 2:1.

c. The new ratio is directly given.

When the new ratio is directly given, the need for calculating it is taken away. But it is important to remember that new ratio is only a first step for further adjustments in accounts on retirement or death.

2. Accounting Treatment of goodwill

Accounting treatment of goodwill on retirement and death is very close to that in admission Following are the different methods followed:

1.  The outgoing partner’s share adjusted in the books

(Margin Adjustment)

This method is similar to the premium method adopted in admission of partners. Under this method the outgoing partner’s share of goodwill is credited to his capital account and the continuing partner’s capital accounts are debited for the same in the “gaining ratio.”

Gaining ratio

Gaining ratio is the ratio of gain. You have seen this in the earlier chapters. Retirement or death of partners is one situation where gaining ratio is applied for adjusting goodwill. When a partner leaves the firm the ratio is revised and the continuing partners will share the outgoing partner’s portion of profit in addition to their old ratio. It is calculated by deducting the old ratio from the new.

Calculation of gaining ratio is important when the partners decide to adjust the outgoing partner’s share of goodwill without raising the goodwill account in the firm.

[Notice that we use sacrificing ratio when the new partner brings in cash for the share of goodwill on admission. Compare the two situations carefully learn thoroughly the difference in accounting treatment.]

2. Goodwill raised in the books

This is the revaluation method of treatment of goodwill. Goodwill is raised in the books of the firm by debiting goodwill account and crediting “all partners’ capital accounts” in the old ratio.

With this journal entry goodwill account is actually opened in the books and will appear in the future balance sheets at its full value. The outgoing partner gets his share of goodwill along with the continuing partners.

If the continuing partners decide to reduce the value of goodwill or to write it off completely they can do so by debiting their capital accounts in the new ratio and crediting the goodwill account with the amount to be reduced. The outgoing partners share or his position is in no way affected due to this step.

3. Revaluation of assets and liabilities

Revaluation of assets and liabilities are done exactly the same way it is done on admission of a partner. The reason behind revaluation in admission or retirement is to make the balance sheet reflect a true and fair view of the assets and liabilities of the firm, prior to making any other major changes in the ownership structure of the business. Any loss or gain in this rearrangement should go to those persons, only to those persons, who are responsible. In other words the incoming new partner in admission or the outgoing partner in retirement or death shall not lose or gain due to wrong valuation of assets and liabilities.

Revaluation is done in the books through a revaluation account. Profit or loss on revaluation is transferred to the capital accounts of all partners (including the outgoing partner) in the old profit sharing ratio.

Remember the rule we follow in admission; “old partners in old ratio”. Here also we apply the same rule. We don’t call them old partners just because we don’t have any “new partner in retirement”. Also notice that the expression “outgoing partner” is used in this book as a convenient term to refer the “retiring partner” as well as the “deceased partner”. Again deceased partner means dead partner. The term deceased sounds less deadly.

4. Reserves and Accumulated profits losses etc.

Accumulated profits, reserves, losses etc. are treated on retirement or death exactly the way they were done in admission. The profits or reserves are transferred to the credit of capital accounts of all partners in the old profit sharing ratio. As a result these items will disappear from the books and from future balance sheets as well. Accumulated losses that are appearing on the asset side of the balance sheet are transferred to the debit side of all partners in the old profit sharing ratio.

5. Adjustment of Joint Life Policy

Joint life policy is a precautionary measure to protect the firm from financial crisis, on account of death of a partner. This is a life insurance policy by which more than one life is insured. In case of a partnership firm all partners are covered usually by a single life insurance policy. The firm, not the partner, pays the premium on this policy. In the event of death of any one of the partners, the insurance company will pay the full amount assured sum to the firm. This amount will be regarded as a special income to the firm and credited to capital accounts of all partners in the profit sharing ratio.

Does it sound little unfair on the part of the continuing partners to share the insurance amount in the profit sharing ratio? How can someone share the life insurance money on the death of another man? This doubt is quite natural.

A person is allowed to take any number of policies on his own life and pay from his private income. Nobody except the legal heirs will get the insurance amount. But the joint life policy discussed here is different. The main aim of this policy is not supporting the family of the partner, but to save the firm from landing into financial crisis due to death of a partner. However this indirectly helps the family of the deceased by quick settlement of dues. Here all the partners (including the deceased one) decided together to insure their lives jointly and pay the premium from the firm’s funds. There is another aspect also to this problem. Suppose the entire insurance claim is credited only to the deceased partner. This will defeat the very purpose for which the policy is taken. The capital account or the amount payable to the executors will directly increase to the extent of the insurance claim. Now firm has to find out other sources of finance to settle original capital investment and reserves. Therefore it is perfectly logical to consider the insurance amount as a business income and share the amount in the normal profit sharing ratio.

Sometimes the partners insure their lives separately and pay the premium from the firm. This will help the continuing partners to keep their life insurance policy valid even after the death of a partner. When there are separate life insurance policies, the full amount due on the policy of deceased partner and the surrender values of the policies of the continuing partners will be credited to all partners in their profit sharing ratio. The surrender values will appear in the subsequent balance sheets.

The following are the three methods of accounting treatment of joint life policies:

i.   The insurance premium treated as normal business expense

When insurance premium is treated as normal business expense, the premium paid will be initially debited to the premium account and later on transferred to the profit and loss account just like any other business expense.

Journal entries

a)        For payment of premium:

Joint life insurance premium account Dr.

         To Cash

b)    For Transfer of expense to P & L account

P & L account Dr.

      To Joint Life Premium Account

c)       At the time of maturity (claim due to death)

Insurance Claim Account Dr. (full amount of insurance policy)

             To All Partner’s Capital Accounts (in the profit sharing ratio)

d)     For cash received

Cash / Bank account Dr.

          To Insurance Claim

Illustration 3.01

A, B, and C sharing profits and losses in the ratio 2:1:1 have taken a joint life policy for Rs.100,000 with an annual premium of Rs.1,000 on 1^st January 2000. C died on 10^th February 2002. The Insurance Company settled the claim on 15^th Feb 2002..Pass necessary journal entries in the books of the firm and show the Joint Life Premium and Insurance Claim accounts.

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