Chapter 2: Reconstitution of a Partnership Firm — Admission of a Partner

Why This Chapter Matters

This chapter is where real accounting starts.

You are no longer just understanding concepts—you are now applying them in real business situations:

• A new partner enters
• Old partners lose profit share
• Assets and liabilities change
• Goodwill comes into play

If this chapter is clear, half of partnership accounting is under control.

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1. What is Reconstitution of a Partnership Firm

Reconstitution means any change in the existing agreement between partners.

This does NOT end the business. It only changes:

• Partners
• Profit-sharing ratio
• Relationship among partners

Reconstitution results in a new agreement but the same firm continues.

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2. Modes of Reconstitution

A partnership firm can be reconstituted in the following ways:

1. Admission of a New Partner

When a new partner joins the firm

2. Change in Profit Sharing Ratio

Existing partners change their ratio

3. Retirement of a Partner

One partner leaves the firm

4. Death of a Partner

Firm continues with remaining partners

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3. Admission of a New Partner

A new partner is admitted when:

• Business needs more capital
• Business needs better management

Important Rule:

A new partner can be admitted only with consent of all existing partners.

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Rights of New Partner

1. Right to share profits
2. Right to share assets

But for this, the partner must bring:

• Capital
• Goodwill (in many cases)

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4. Key Adjustments at the Time of Admission

This is the most important part of the chapter.

At the time of admission, the following adjustments are required:

1. New Profit Sharing Ratio
2. Sacrificing Ratio
3. Goodwill valuation and adjustment
4. Revaluation of assets and liabilities
5. Distribution of reserves and profits
6. Adjustment of capital

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5. New Profit Sharing Ratio

When a new partner enters:

• Old partners sacrifice part of their profit
• New partner gets that share

Basic Formula:

New Share = Remaining Share × Old Ratio

Key Concept:

If not specified → new partner gets share from old partners in their old ratio

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6. Sacrificing Ratio

Sacrificing ratio tells:
How much each old partner is giving up

Formula:

Sacrifice = Old Share – New Share

Why It Matters:

This ratio is used to distribute goodwill compensation

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7. Goodwill (Critical Concept)

Goodwill is the value of reputation of a business.

It is an intangible asset.

Goodwill is the value of expected excess profits of a firm over normal profits.

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Why Goodwill is Important

When a new partner enters:

• He benefits from existing reputation
• Old partners lose part of future profits

So:
New partner must compensate old partners → called premium for goodwill

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8. Factors Affecting Goodwill

• Nature of business
• Location
• Management efficiency
• Competition
• Special advantages (brand, patents, contracts)

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9. Methods of Valuation of Goodwill

1. Average Profit Method

Goodwill = Average Profit × Number of Years

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2. Super Profit Method

Super Profit = Actual Profit – Normal Profit

Goodwill = Super Profit × Number of Years

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3. Capitalisation Method

Two approaches:

• Capitalisation of average profits
• Capitalisation of super profits

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10. Treatment of Goodwill

Case 1: New Partner Brings Goodwill in Cash

Entry:

• Debit Bank
• Credit Premium for Goodwill
• Transfer to old partners in sacrificing ratio

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Case 2: Goodwill Not Brought

• Debit new partner’s current account
• Credit old partners’ capital accounts

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Case 3: Goodwill Already Exists in Books

• First write it off
• Then adjust new goodwill

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Hidden Goodwill

Sometimes goodwill is not given.

It is calculated using:

Hidden Goodwill = Total Capital (implied) – Actual Capital

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11. Adjustment of Accumulated Profits and Losses

Old profits belong only to old partners.

Examples:

• General Reserve
• Profit & Loss Balance

These are transferred to old partners in old ratio

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12. Revaluation of Assets and Liabilities

Before admitting a new partner:

• Assets must reflect real value
• Liabilities must be correct

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Revaluation Account

Used to record:

• Increase in assets → gain
• Decrease in assets → loss
• Increase in liabilities → loss
• Decrease in liabilities → gain

Final profit/loss is transferred to old partners in old ratio

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13. Important Journal Entries

Increase in Asset

Asset A/c Dr.
To Revaluation A/c

Decrease in Asset

Revaluation A/c Dr.
To Asset A/c

Increase in Liability

Revaluation A/c Dr.
To Liability A/c

Decrease in Liability

Liability A/c Dr.
To Revaluation A/c

Transfer of Profit

Revaluation A/c Dr.
To Old Partners’ Capital A/c

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14. Adjustment of Capital

After admission:

• Capital may be adjusted based on new ratio
• Excess or deficiency is adjusted in cash

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15. What Students Get Wrong

• Confusing sacrificing ratio with new ratio
• Skipping goodwill adjustment
• Ignoring revaluation account
• Using new ratio instead of old ratio in adjustments
• Forgetting hidden goodwill

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Final Understanding

This chapter is about fairness in partnership.

When a new partner enters:

• Old partners must be compensated
• Assets must reflect true value
• Profits must be fairly distributed

If you understand:

• Sacrificing ratio
• Goodwill
• Revaluation

Then numericals become systematic, not confusing.

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