Changes in Partnership and its treatment in books of accounts
Changes in Partnership
A change in partnership occurs
when the contents of the partnership agreement change. This could occur when
there is:
1. Admission of a new partner,
2. Change of profit sharing plan,
and
3. Retirement or death of a partner.
Technically a change in
partnership gives rise to dissolution of an existing relationship and creation
of another.
1. Admission of a New Partner
Admission of a new partner be agreed
upon by all existing partners. There are two ways a partner can be admitted
into an existing partnership. One is by buying interest from an existing
partner and the other is by buying a share of interest from the firm.
Buying interest from an existing partner
Admission of a new
partner can be effected by the new partner buying interest from an existing
partner. Accounting treatment for such an arrangement is straight forward. An
existing partner's interest in the firm is decreased and a new partner is given
a share of interest given up by the existing partner. Consideration can be
passed privately between the two partners or can be recorded through the
partnership books.
The following journal
entry is made to record such form of admission:
|
Date
|
Description
|
Folio
|
Debit
|
Credit
|
|
Jan
1
|
Capital Account [existing partner]
|
|
500,000
|
|
|
|
Capital
Account [new partner]
|
|
|
500,000
|
|
|
To record transfer of share of
ownership to an incoming partner.
|
|
|
|
Buying a share of partnership interest from the firm
In this mode of
admission all existing partners' shares of interest are affected. When a new
partner is admitted he is expected to contribute to the partnership an amount
commensurate with the share of the business he is expected to own. At the point
of admission the total of capital and current accounts of individual partners
represent the net assets of the firm. However, the net assets figure may not
reflect the value of a business. It is normal for a firm to be worth more than
the sum of its individual assets net of all liabilities.
Tangible assets could
have a higher or lower values than those carried in the books of accounts. This
calls for revaluation of assets before admission of a new partner in order that
changes [increases or decreases] in values of these assets are attributed to
existing partners who contributed towards such changes in value.
Even when tangible
assets have been revalued it is possible for a firm to attract a value higher
than the sum of all tangible assets. This is attributed to the existence of an
intangible asset called goodwill. Goodwill may exist in a firm because of:
·
being conveniently located
·
having loyal customers
·
having good competent management
·
having partners of good reputation.
These attributes are
intangible and difficult to quantify and value. Consequently, goodwill can only
be estimated. There are several approaches to estimating goodwill.
Methods of Estimating Goodwill
1. Revenue based methods
This approach estimates
goodwill as for example "n years purchase of annual sales of the past y
years". The methodology involves getting average annual sales of the past
'y' years and multiplying the average annual sales figure with "n".
2. Profit based methods
In principle this is
similar to the revenue based method. In the profit based method the basis for
estimation is average profit rather than average revenue.
3. Capitalization of Average Super Profits
Super profits are profits in excess of what is
required to earn a normal return on capital in a business. Super profit is
estimated and capitalized for an agreed time period using the normal rate of
return. Capitalization of super profits requires application of the concept of
time value of money. Retirement of a Partner
Where there is no fixed term a partner
may retire by giving notice of his intention to all partners.
In the absence of any agreement
to the contrary an outgoing partner is entitled to opt
for the share of profits made since his retirement or to interest at the rate
of 5% per annum on the amount of his share of partnership assets, if his share
was not paid to him on retirement.
If a retiring partner's share of
partnership assets is not paid out on the date of retirement it becomes a debt to
the partnership. Subject to any agreement the amount due from continuing
partners is a debt accruing at the date of dissolution . For the
purpose of establishing the date of dissolution where a partnership is dissolved
by notice, the effective date is the date mentioned on the notice or if no date
is mentioned, as from date of communication of notice.
There are two ways of effecting
retirement of a partner:
Remaining partners may
purchase outgoing partner's interest in the firm, or
Retiring partner is
paid out of the firm's assets.
1. Purchase of interest by remaining partners
In this case the remaining
partners divide up the capital share of a retiring partner. Consideration can
be paid privately or that payment can be recorded through partnership books. In
any case this approach does not result in a change of partnership's net assets.
2. Purchase of interest of the retiring partner by the firm
When a partner retires and is to
be paid out of firm's assets the partnership agreement needs to be consulted
for guidance. In the absence of any agreement a retiring partner is entitled to
his share of net assets of the firm.
When a partner retires Statement
of Financial Position values may not represent properly net assets of a firm. As
such, a retiring partner is entitled to have assets revalued and goodwill
recognized. Usually continuing partners will not wish to maintain a goodwill
account in the books or assets at their revised values.
Changes in Partnership during an Accounting Period
Admissions and retirements can be
effected at any time during an accounting period. So far examples have involved
changes in partnership occurring at the end or beginning of an accounting
period.
Where changes occur during an
accounting period a trading Statement of Comprehensive Income account for the
period has to be prepared up to the date of change and also a Statement of
Financial Position as at that date. When financial statements are prepared
immediately after such a change, the new arrangement starts with the books of
accounts which reflect the new arrangement. However, in a number of cases
changes occur during the year and these are not reflected until after financial
statements have been prepared at the end of the year.
In these cases, the approach is
to apportion results of operations such that results of the period before
change are reported separately from the results after change. This is done
because a change in partnership may result in a change in profit sharing plan. Therefore,
a profit sharing plan ruling before change should apply to the results before
change and the profit sharing plan ruling after change should apply to results
after change.
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