Retirement and Death of a Partner | ISC Class 12 Accounts Notes

This note covers the retirement and death of a partner: calculating the new profit-sharing ratio, gaining ratio and sacrificing ratio; the treatment of goodwill including hidden goodwill; adjustment of undistributed profits and losses; working out the retiring or deceased partner's share of profit up to the date of retirement or death; preparing the Revaluation Account; adjusting the continuing partners' capitals; calculating and settling the amount due to the retiring partner; preparing the retiring partner's loan account and the deceased partner's executor's loan account, with interest accrued and due and interest accrued but not due; and the accounting treatment required when there is a change in the profit-sharing ratio of the continuing partners.

What happens to a firm when a partner retires or dies?

When a partner leaves a firm by retirement or by death of a partner, the existing partnership deed comes to an end, and the remaining partners continue the business on new terms.

In both cases the firm must work out the sum due to the outgoing partner (the retiring partner himself, or the legal representatives of a deceased partner) after making adjustments for goodwill, revaluation of assets and liabilities, and accumulated profits and losses. In India, where there is no agreement on a point, the matter is settled under the Indian Partnership Act, 1932.

Which accounting aspects are involved?

The accounting aspects involved are the same in both situations: ascertaining the new profit-sharing ratio and gaining ratio, treatment of goodwill, revaluation of assets and liabilities, adjustment for unrecorded assets and liabilities, distribution of accumulated profits and losses, ascertainment of the outgoing partner's share of profit or loss up to the date of retirement or death, adjustment of capitals if required, and settlement of the amount due.

What does the outgoing partner's final claim include?

The sum due to the outgoing partner includes the credit balance of his capital account and current account, plus his share of goodwill, his share of accumulated profits, his share of any gain on revaluation, his share of profit up to the date of leaving, and any interest on capital or salary due to him.

Deductions include a debit balance in his current account, his share of goodwill to be written off, his share of accumulated losses, his share of loss on revaluation, his drawings, and interest on drawings.

The outgoing partner's final claim is therefore a net figure: additions less deductions, as worked out in his capital account before any closing entries are passed.

How are the new profit-sharing ratio, gaining ratio and sacrificing ratio calculated?

New profit-sharing ratio and gaining ratio

The new profit-sharing ratio is the ratio in which the remaining partners share future profits after a partner retires or dies. New Share = Old Share + Acquired Share, where the acquired share is what a continuing partner takes over from the outgoing partner.

Definition: Gaining ratio. The ratio in which the continuing partners acquire the share of profit given up by the retiring or deceased partner is called the gaining ratio.

If nothing is stated, it is assumed that the continuing partners acquire the outgoing partner's share in their old profit-sharing ratio, so the new ratio among them stays the same as their old ratio.

For example, if Asha, Deepti and Nisha share profits in the ratio of 3:2:1 and Deepti retires, the new ratio between Asha and Nisha remains 3:1 unless they decide otherwise.

When the continuing partners acquire the outgoing partner's share in some other agreed proportion, the new share of each continuing partner equals his old share plus the share he acquires from the outgoing partner.

When a specified new profit-sharing ratio is agreed directly, that ratio is simply used. The gaining ratio is calculated whenever the new ratio of the continuing partners is given directly, using Gaining Share = New Share − Old Share.

Sacrificing ratio

A sacrificing ratio works the other way: it is the ratio in which a partner (continuing or outgoing) gives up a share of profit in favour of another.

Whenever a continuing partner's new share works out lower than his old share, he has sacrificed, and his capital account is compensated accordingly, along with the outgoing partner's.

The calculation is the mirror image of the gaining ratio: Sacrificing Share = Old Share − New Share. A partner whose old share is larger than his new share has sacrificed the difference, and a partner whose two shares are equal has neither gained nor sacrificed.

Worked example 1. Deepa, Neeru and Shilpa were partners sharing profits in the ratio of 5:3:2. Neeru retired and the new profit-sharing ratio between Deepa and Shilpa was 2:3. Calculate the gaining ratio and the sacrificing ratio of the continuing partners.

Answer: Deepa's old share is 5/10 and her new share is 2/5 = 4/10, so her sacrificing share = 5/10 − 4/10 = 1/10. Shilpa's old share is 2/10 and her new share is 3/5 = 6/10, so her gaining share = 6/10 − 2/10 = 4/10.

Deepa has therefore sacrificed 1/10 while Shilpa has gained 4/10, of which 3/10 is Neeru's share and 1/10 is Deepa's sacrifice. Only Shilpa gains and, among the continuing partners, only Deepa sacrifices, so Shilpa alone compensates both Neeru, for his 3/10, and Deepa, for her 1/10.

How is goodwill adjusted, including hidden goodwill?

The outgoing partner is entitled to his share of goodwill because it was earned with the efforts of all the partners who worked in the firm.

The partner is compensated for his share of goodwill by the gaining partners, in their gaining ratio, because they are the ones who benefit from acquiring extra profit share.

When goodwill does not appear in the books

When goodwill does not already appear in the books, the gaining partners' capital accounts are debited individually in their gaining ratio, and the outgoing partner's capital account is credited with his share of goodwill: Gaining Partners' Capital A/c Dr. (individually) To Outgoing Partner's Capital A/c.

Worked example 1. Keshav, Nirmal and Pankaj are partners sharing profits and losses in the ratio of 4:3:2. Nirmal retires and the goodwill of the firm is valued at ₹72,000.

Keshav and Pankaj decide to share future profits in the ratio of 5:3. Record the journal entry for the adjustment of goodwill.

Answer: Nirmal's old share is 3/9, so his share of goodwill = ₹72,000 × 3/9 = ₹24,000. Keshav's gaining share works out to 13/72 and Pankaj's gaining share to 11/72, giving a gaining ratio of 13:11.

Keshav's share of the payment = ₹24,000 × 13/24 = ₹13,000, and Pankaj's share = ₹24,000 × 11/24 = ₹11,000. The journal entry is: Keshav's Capital A/c Dr. ₹13,000, Pankaj's Capital A/c Dr. ₹11,000, To Nirmal's Capital A/c ₹24,000.

(to draw) Draw a bar chart with one bar for each of Keshav, Nirmal and Pankaj's capital account. Show Keshav's and Pankaj's bars reduced by ₹13,000 and ₹11,000 respectively (debited) and Nirmal's bar increased by ₹24,000 (credited), so the three bars together show the ₹24,000 goodwill moving from the gaining partners to the retiring partner without changing the firm's total capital.

When goodwill already appears in the books, and hidden goodwill

If goodwill already appears in the books at some value, it is first written off by debiting all partners' capital accounts (including the outgoing partner's) in the old profit-sharing ratio and crediting the Goodwill Account; after which the outgoing partner's revalued share of goodwill is adjusted through the gaining partners as above.

Definition: Hidden goodwill. When the firm agrees to pay the outgoing partner a lump sum, the excess of that lump sum over the balance worked out in his capital account after all other adjustments is treated as his share of goodwill, even though goodwill is never separately valued or named.

If a continuing partner also sacrifices part of his future share as a result of the new ratio, his capital account is credited (along with the outgoing partner's) in proportion to his sacrifice, while the other continuing partners who gain are debited in proportion to their gain.

How are undistributed profits and losses adjusted?

A firm's Balance Sheet may show accumulated profits, such as a General Reserve, or accumulated losses, such as a debit balance in the Profit and Loss Account.

The outgoing partner is entitled to his share of accumulated profits and is liable for his share of accumulated losses.

Since these belong to all the partners for the period before the reconstitution, they are transferred to the capital accounts of all partners, including the outgoing partner, in the old profit-sharing ratio, and not in the new ratio, because the reserve or loss built up while the old ratio was still in force.

For a reserve: Reserves A/c Dr. To All Partners' Capital A/c's (individually). For an accumulated loss: All Partners' Capital A/c's (individually) Dr. To Profit and Loss A/c.

Worked example 2. Inder, Gajender and Harinder are partners sharing profits in the ratio of 3:2:1. Inder retires. On the date of retirement, the Balance Sheet of the firm shows a General Reserve of ₹90,000. Show how the reserve is distributed.

Answer: Since the reserve was earned before the reconstitution, it is transferred to all three partners' capital accounts in the old profit-sharing ratio of 3:2:1, and not in any new ratio. Inder's share = ₹90,000 × 3/6 = ₹45,000.

Gajender's share = ₹90,000 × 2/6 = ₹30,000. Harinder's share = ₹90,000 × 1/6 = ₹15,000. The journal entry is: General Reserve A/c Dr. ₹90,000, To Inder's Capital A/c ₹45,000, To Gajender's Capital A/c ₹30,000, To Harinder's Capital A/c ₹15,000.

This single transfer closes the Reserve Account for good; it is not reopened or redistributed again once the firm starts operating under its new profit-sharing ratio.

How is the outgoing partner's share of profit up to the date of leaving worked out?

Retirement normally takes place at the end of an accounting year, but a partner may retire, or die, in the middle of the year.

The outgoing partner's claim then also includes his share of profit or loss, interest on capital and interest on drawings from the date of the last Balance Sheet to the date of retirement or death.

Time basis and turnover basis

Since closing the books mid-year is inconvenient, this interim share of profit is usually estimated on the basis of time or on the basis of turnover, using the previous year's profit or the average of recent years' profits.

Average Profit = Total Profit ÷ Years. On a time basis, the outgoing partner's share of profit equals the chosen profit figure, multiplied by the proportion of the accounting year that has elapsed, multiplied by his own share.

On a turnover basis, the profit for the period is estimated from the ratio of sales in the period to total sales for the preceding year, and the outgoing partner's share is then taken out of that estimated profit.

Worked example 3. A partner retires on 30th June after sharing profits and losses with two other partners. Sales for the preceding full year were ₹8,00,000, on which the profit was ₹1,00,000.

Sales for the period from the start of the new year to the date of retirement were ₹1,50,000.

Calculate the profit for the period and the retiring partner's share, given that his share works out to four-tenths of the firm's profit.

Answer: Profit per rupee of sales in the preceding year = ₹1,00,000 ÷ ₹8,00,000. Profit for the intervening period = ₹1,00,000 × (₹1,50,000 ÷ ₹8,00,000) = ₹18,750. The retiring partner's share = ₹18,750 × 4/10 = ₹7,500.

The entry is: Profit & Loss Suspense A/c Dr. ₹7,500, To Retiring Partner's Capital A/c ₹7,500.

Journal entries for the interim period

Where there is no change in the profit-sharing ratio of the remaining partners, the interim share is recorded through a Profit & Loss Suspense Account: this account is debited and the outgoing partner's capital account is credited, and the Profit & Loss Suspense Account is later closed by debiting the gaining partners' capital accounts in their gaining ratio.

Where there is a change in the profit-sharing ratio of the remaining partners, the entry may instead be made directly through the gaining partners' capital or current accounts, debiting them and crediting the outgoing partner.

How is the Revaluation Account prepared on retirement or death?

Definition: Revaluation Account. A nominal account prepared, as on admission of a partner, to record increases and decreases in the book values of assets and liabilities and to bring unrecorded assets and liabilities into the books, so that the net gain or loss is shared by all partners, including the outgoing one, in the old profit-sharing ratio.

The Revaluation Account is prepared because some assets and liabilities may not be shown at their current worth, and there may be unrecorded items that have never entered the books at all; without this adjustment, the gain or loss on such items would wrongly fall on the continuing partners alone under the new ratio, instead of being shared by everyone, including the outgoing partner, in the ratio that applied while the gain or loss was actually building up.

Journal entries for revaluation

An increase in the value of an asset is credited to the Revaluation Account and the asset account is debited. A decrease in the value of an asset is debited to the Revaluation Account and the asset account is credited.

An increase in a liability is debited to the Revaluation Account and the liability account credited; a decrease in a liability is credited to the Revaluation Account and the liability account debited.

An unrecorded asset brought into the books is credited to the Revaluation Account; an unrecorded liability brought into the books is debited to the Revaluation Account.

Sharing the net profit or loss

The resulting net profit or loss on revaluation is transferred to all partners' capital accounts in the old profit-sharing ratio: Revaluation A/c Dr. To All Partners' Capital A/c's for a profit, or the reverse for a loss.

Draw a two-sided "T" account headed Revaluation Account. On the debit side list decreases in asset values and increases in liabilities, ending with the profit transferred to all partners' capital accounts (in old ratio) if the credit side total is larger.

On the credit side list increases in asset values, decreases in liabilities and any unrecorded assets, ending with a loss transferred to capital accounts if the debit side total is larger.

How are the continuing partners' capitals adjusted?

At the time of retirement or death, the remaining partners may decide to adjust their capitals to be proportionate to the new profit-sharing ratio, instead of leaving the old balances unchanged. This can be done in any one of three ways, depending on what the partners agree.

Ways to fix the continuing partners' capitals

1. When the total capital of the new firm is specified by the partners, each continuing partner's new capital is his share of that fixed total, calculated in the new profit-sharing ratio; any surplus in his existing (adjusted) capital is withdrawn, and any deficiency is brought in as cash.
2. When the total capital of the new firm is not specified, the sum of the continuing partners' adjusted capital balances is itself taken as the total capital of the new firm, and this total is then divided between them in the new profit-sharing ratio, with cash brought in or withdrawn as needed to match.
3. When the continuing partners agree to bring in cash to pay off the outgoing partner in such a way that their own capitals become proportionate to their new profit-sharing ratio, the total capital of the new firm is the sum of the continuing partners' adjusted capitals plus the amount payable to the outgoing partner, and this total is divided between the continuing partners in the new ratio.
4. In every case, a continuing partner whose adjusted capital is below his calculated new capital brings in the shortfall in cash, and a partner whose adjusted capital is above his calculated new capital withdraws the excess in cash.

Why the method matters

Choosing the right method matters because each one starts from a different total capital figure, so the same partner's cash to be brought in or withdrawn can differ considerably depending on which of the three bases the partnership deed, or the partners on retirement, agree to use.

How is the amount due to the retiring partner calculated and paid?

The outgoing partner's account is settled as the partnership deed provides: in a lump sum immediately, in instalments with or without interest, or partly in cash immediately and partly in instalments.

Settlement under Section 37 of the Indian Partnership Act, 1932

In the absence of any agreement, Section 37 of the Indian Partnership Act, 1932 applies in India: the outgoing partner may choose either interest at 6% per annum on the amount due until payment, or such share of profits as has been earned using his money, based on the capital ratio.

Interest = Principal × Rate × Time gives the amount of interest payable for any period the balance remains unpaid.

Paying through a loan account

If the firm cannot pay the whole amount immediately, the balance due is transferred to the outgoing partner's loan account, and the journal entries used depend on how payment is made: full payment in cash (debit the partner's capital account, credit cash/bank); the whole amount treated as a loan (debit capital, credit loan account); part cash and part loan (debit capital for the total, credit cash/bank for the part paid and credit the loan account for the balance); or, where the loan is repaid in instalments, interest is first credited to the loan account (debit Interest A/c, credit loan account) and each instalment is then paid off (debit loan account, credit cash/bank).

Worked example 4. On retirement, ₹60,000 becomes due to a partner, to be paid in four yearly instalments plus interest at 12% per annum on the unpaid balance. Work out the first year's interest and instalment, and the balance carried forward.

Answer: Interest for Year 1 = ₹60,000 × 12% = ₹7,200. The instalment paid is ₹15,000 (one-quarter of the principal) plus ₹7,200 interest = ₹22,200.

The loan account is credited at the start with ₹60,000 and the interest of ₹7,200, and debited with the ₹22,200 paid, leaving a balance carried forward of ₹45,000 (₹60,000 − ₹15,000) to Year 2.

(to draw) Plot year number (1 to 4) on the horizontal axis and the loan balance outstanding on the vertical axis. Starting at ₹60,000 in Year 1, the balance steps down by ₹15,000 each year as the equal instalment of principal is repaid (₹45,000, ₹30,000, ₹15,000 and finally nil), while the interest charged each year falls in step with the declining balance, so the curve is a straight downward staircase to zero.

The balance of the loan account is shown on the liabilities side of the Balance Sheet until the last instalment is paid.

How is the retiring partner's loan account and the deceased partner's executor's loan account prepared?

Retiring partner's loan account

Once the outgoing partner's final claim is worked out in his capital account, after adjusting goodwill, revaluation, reserves and his interim share of profit, the balance is transferred either to a retiring partner's loan account, if it is to be paid over time, or to the deceased partner's executor's loan account, which records what is owed to his legal representatives.

Where the balance is repaid in instalments that carry interest, each instalment includes interest and part of the principal.

The loan account is credited at the start with the amount transferred from the capital account. Each year it is credited again with the interest for the year and debited with the cash paid, so the closing balance falls period by period until the loan is fully cleared.

Interest accrued and due and interest accrued but not due

Interest that has fallen due for payment on the date it is being calculated is interest accrued and due; interest that has been earned for part of a period but whose instalment date has not yet arrived is interest accrued but not due.

Interest accrued and due is interest for a period that has ended on an instalment date. It is credited to the loan account, Interest on Loan A/c Dr. To Retiring Partner's Loan A/c, and it is paid with that instalment, so the payment is debited to the loan account.

Interest accrued but not due is interest for the part of a period from the last instalment date to the date the books are closed. It is credited by the same entry, Interest on Loan A/c Dr. To Retiring Partner's Loan A/c, but nothing is paid against it yet, so it stays in the balance carried down and is shown with the loan on the liabilities side of the Balance Sheet.

Both must be worked out correctly so that the loan or executor's account balance carried forward is accurate, and the same treatment applies whether the person being paid is the retiring partner himself or the executors of a deceased partner.

Worked example 2. On 1st April a partner retires and ₹1,20,000 due to him is transferred to his loan account, carrying interest at 12% per annum payable yearly on 31st March. The firm pays ₹40,000 on 31st March each year towards interest and principal. Show the loan account for the first two years.

Answer: Year 1 interest = ₹1,20,000 × 12% = ₹14,400. The loan account is credited with ₹14,400 and debited with ₹40,000, leaving a balance of ₹94,400 (₹1,20,000 + ₹14,400 − ₹40,000).

Year 2 interest = ₹94,400 × 12% = ₹11,328. The loan account is credited with ₹11,328 and debited with ₹40,000, leaving a balance of ₹65,728 (₹94,400 + ₹11,328 − ₹40,000). The interest falls each year as the principal is repaid.

Deceased partner's executor's loan account

On the death of a partner, his capital account is closed by transferring the balance to the deceased partner's executor's loan account, which is opened in the name of his legal representatives.

The executor's loan account is then credited each year with interest and debited with whatever is paid to the executors, exactly as a retiring partner's loan account is, and any balance still unpaid is shown on the liabilities side of the Balance Sheet.

Worked example 3. Anil died on 1st October. After all adjustments, ₹57,000 stood to the credit of his capital account. Half of the amount due was paid to his executors immediately and the balance was transferred to the executor's loan account, carrying interest at 10% per annum. Show the executor's loan account for the six months to 31st March.

Answer: Amount paid immediately = ₹57,000 × 1/2 = ₹28,500. Amount transferred to the executor's loan account = ₹57,000 − ₹28,500 = ₹28,500.

Interest for six months = ₹28,500 × 10/100 × 6/12 = ₹1,425. The executor's loan account is credited with the ₹28,500 transferred from Anil's capital account and with interest of ₹1,425 for the six months. The ₹28,500 paid at once never passes through this account, so the balance carried down on 31st March is ₹28,500 + ₹1,425 = ₹29,925.

How is the executor's account closed on final payment?

The executor's loan account is a liability of the firm until the last rupee is paid. Each year the firm credits the account with the interest for the year and debits it with the cash paid to the executors, so the balance falls steadily.

When the final instalment is paid, the account is closed and nothing remains on the liabilities side of the Balance Sheet. The same closing procedure applies to a retiring partner's loan account.

If the firm pays the executors in full at once, the capital account is simply debited and bank credited, and no loan account is opened at all.

What happens when there is a change in the profit-sharing ratio of the continuing partners?

A change in the profit-sharing ratio of the continuing partners takes place at the time of retirement or death of a partner, because the outgoing partner's share has to be redistributed among the remaining partners in some agreed proportion.

Treatment of accumulated profits and losses

Accumulated profits and losses can then be adjusted through a single journal entry instead of being distributed to all partners and then redistributed afresh: the gaining partners' capital/current accounts are debited and the sacrificing partners' capital/current accounts are credited for profits, with the reverse treatment applied when the item is a loss rather than a profit.

This single-entry method is more efficient than crediting every partner with his old-ratio share of a reserve and then debiting the same partners again in the new ratio, because the two steps net off to leave only the gain or sacrifice actually involved; it is applied, in particular, to each of the items listed below.

Items covered by this treatment

A credit balance item, such as the General Reserve, the Workmen Compensation Reserve, the Investment Fluctuation Reserve, the Contingency Reserve, and a credit balance in the Profit and Loss Account, is treated as an accumulated profit: the gaining partner's capital or current account is debited and the sacrificing partner's capital or current account is credited.

A debit balance item, such as a Profit and Loss Account debit balance or the Advertisement Suspense Account (which represents unwritten-off deferred revenue expenditure), is treated as an accumulated loss: the sacrificing partner's capital or current account is debited and the gaining partner's capital or current account is credited, since the sacrificing partner is being relieved of a loss that would otherwise have fallen more heavily on him under the old ratio.

The Balance Sheet prepared on retirement or death of a partner must be drawn up in the horizontal format only, with liabilities on one side and assets on the other.

The Memorandum Revaluation Account, and the Joint Life Policy and Individual Life Policy methods, are not used in the accounts of a reconstituted firm on retirement or death of a partner.

What are the advantages and limitations of settling a retiring partner's dues through a loan account?

When a firm cannot pay a retiring or deceased partner's dues in full at once, it transfers the unpaid balance to a loan account or an executor's account rather than leaving the amount sitting unpaid in the capital account. This choice has both advantages and limitations for the firm and for the person being paid.

Advantages

Transferring the unpaid balance to a retiring partner's loan account lets the firm settle its obligation without disturbing its working capital all at once.

The outgoing partner continues to earn interest, either at the rate agreed in the deed or, failing agreement, at 6% per annum under the Indian Partnership Act, 1932, so his dues are not left unremunerated while unpaid.

Paying in instalments also spreads the cash outflow over several years, which suits a firm whose assets are not easily converted into cash immediately.

Limitations

A loan account creates a continuing liability that must be shown in the Balance Sheet until fully repaid, which can make the firm's position look less liquid to outsiders such as creditors or bankers.

The continuing partners must also calculate interest accrued and due, and interest accrued but not due, correctly each year, which adds to the bookkeeping.

If the firm is unable to pay the agreed instalments, it may face a dispute with the retiring partner or his legal representatives, who have the right to insist on repayment according to the agreed terms.

Glossary

• Retirement — withdrawal of a partner from a firm with the consent of the other partners, while the firm continues with the remaining partners.
• Death of a partner — the end of a partner's membership of the firm on account of death, which also leads to reconstitution of the firm.
• New profit-sharing ratio — the ratio in which the remaining partners share future profits after a partner retires or dies.
• Gaining ratio — the ratio in which the continuing partners acquire the share of profit given up by the retiring or deceased partner.
• Sacrificing ratio — the ratio in which a partner gives up a share of profit in favour of another partner.
• Hidden goodwill — the excess of a lump sum paid to an outgoing partner over the adjusted balance in his capital account, treated as his share of goodwill.
• Revaluation Account — a nominal account prepared to record the net gain or loss on revaluing assets and liabilities and on bringing unrecorded items into the books.
• Profit & Loss Suspense Account — a temporary account recording an outgoing partner's share of profit for the period up to retirement or death, when the firm's books are not closed mid-year.
• Executor's loan account — the account of a deceased partner's legal representative to which the amount finally due to the deceased partner is transferred for settlement.
• Retiring partner's loan account — the account to which the balance due to a retiring partner is transferred when the firm cannot pay him immediately in full.
• Interest accrued and due — interest on a loan that has fallen due for payment on the date it is being calculated.
• Interest accrued but not due — interest earned on a loan for part of a period whose payment date has not yet arrived, added to the loan balance.
• Workmen Compensation Reserve — a reserve set aside to meet possible claims for compensation that employees might make against the firm.
• Investment Fluctuation Reserve — a reserve created to absorb a fall in the market value of investments below their book value.
• Horizontal format — a Balance Sheet layout showing liabilities on one side and assets on the other, required for retirement or death of a partner.

Common errors and misconceptions

• Misconception: The new profit-sharing ratio is always equal among the continuing partners. Correct: Unless otherwise agreed, continuing partners acquire the outgoing partner's share in their old ratio, so the new ratio usually equals their old ratio.
• Misconception: Goodwill is adjusted through all partners' capital accounts in the new ratio. Correct: Goodwill is adjusted by debiting only the gaining partners' capital accounts, in their gaining ratio, and crediting the outgoing partner.
• Misconception: Hidden goodwill can only arise when the word "goodwill" is mentioned in the problem. Correct: Hidden goodwill is simply the excess of a lump sum settlement over the adjusted capital balance, even when goodwill is never named.
• Misconception: Reserves and accumulated losses are shared in the new profit-sharing ratio. Correct: Accumulated profits and losses belong to all partners up to that date and are shared in the old profit-sharing ratio.
• Misconception: The retiring partner's loan account and the deceased partner's executor's loan account need no separate interest calculation. Correct: Both must distinguish interest accrued and due from interest accrued but not due when instalments are repaid.
• Misconception: Revaluation profit or loss is shared only among the continuing partners. Correct: The Revaluation Account's profit or loss is shared by all partners, including the outgoing one, in the old profit-sharing ratio.
• Misconception: The Balance Sheet after retirement or death may be prepared in either format. Correct: It must be prepared in the horizontal format only.
• Misconception: The Memorandum Revaluation Account and Joint Life Policy methods must be used on retirement or death. Correct: Both are excluded; only the ordinary Revaluation Account method is used.

Exam-style questions with model answers

Q1. Choose the correct option. In the absence of any information about how the remaining partners acquire the share of a retiring partner, they are assumed to acquire it in: (a) the new profit-sharing ratio, (b) the old profit-sharing ratio, (c) an equal ratio, (d) the gaining ratio. [1 mark]

1. The correct option is (b), the old profit-sharing ratio.
2. In that case the new ratio among the continuing partners is the same as their old ratio, and the gaining ratio equals the old ratio.

Q2. State the meaning of interest accrued but not due on a retiring partner's loan. [2 marks]

1. It is interest that has been earned on the loan for part of a period, but whose payment date has not yet arrived on the date the accounts are prepared.
2. It is added to the balance of the loan account and shown on the liabilities side of the Balance Sheet, unlike interest accrued and due, which is a liability payable at once.

Q3. Anand, Bahadur and Chander are partners sharing profits equally. On Chander's retirement, his share is acquired by Anand and Bahadur in the ratio of 3:2. Calculate the new profit-sharing ratio and the gaining ratio of Anand and Bahadur. [3 marks]

1. Chander's share is 1/3. Anand acquires 3/5 of it = 3/5 × 1/3 = 1/5, and Bahadur acquires 2/5 of it = 2/5 × 1/3 = 2/15.
2. Anand's new share = 1/3 + 1/5 = 8/15, and Bahadur's new share = 1/3 + 2/15 = 7/15, so the new profit-sharing ratio is 8:7.
3. The gaining ratio is the ratio in which they acquired Chander's share, that is 1/5 : 2/15 = 3:2.

Q4. Hanny, Pammy and Sunny are partners sharing profits in the ratio of 3:2:1. Goodwill appears in the books at ₹60,000. Pammy retires and the goodwill of the firm is now valued at ₹84,000. Hanny and Sunny decide to share future profits in the ratio of 2:1. Pass the journal entries for the treatment of goodwill. [4 marks]

1. The existing goodwill of ₹60,000 is written off in the old ratio of 3:2:1: Hanny's Capital A/c Dr. ₹30,000, Pammy's Capital A/c Dr. ₹20,000, Sunny's Capital A/c Dr. ₹10,000, To Goodwill A/c ₹60,000.
2. Pammy's share of the current value of goodwill = ₹84,000 × 1/3 = ₹28,000.
3. Hanny's gaining share = 2/3 − 3/6 = 1/6, and Sunny's gaining share = 1/3 − 1/6 = 1/6, so the gaining ratio is 1:1.
4. The entry is: Hanny's Capital A/c Dr. ₹14,000, Sunny's Capital A/c Dr. ₹14,000, To Pammy's Capital A/c ₹28,000, being Pammy's share of goodwill adjusted to the extent of their gain.

Q5. Asha, Deepa and Lata are partners sharing profits in the ratio of 3:2:1. Deepa retires. After all adjustments for revaluation, goodwill and accumulated profits, the capital accounts of Asha and Lata show credit balances of ₹1,60,000 and ₹80,000 respectively. It is decided to adjust their capitals in the new profit-sharing ratio of 3:1. Calculate the new capitals and the cash to be brought in or withdrawn, and record the journal entries. [5 marks]

1. The total capital of the new firm is taken as the sum of the adjusted capitals of the continuing partners = ₹1,60,000 + ₹80,000 = ₹2,40,000.
2. Asha's new capital = ₹2,40,000 × 3/4 = ₹1,80,000, and Lata's new capital = ₹2,40,000 × 1/4 = ₹60,000.
3. Asha's existing capital is ₹1,60,000 against a new capital of ₹1,80,000, so she brings in ₹20,000 in cash.
4. Lata's existing capital is ₹80,000 against a new capital of ₹60,000, so she withdraws ₹20,000 in cash.
5. The entries are: Bank A/c Dr. ₹20,000, To Asha's Capital A/c ₹20,000; and Lata's Capital A/c Dr. ₹20,000, To Bank A/c ₹20,000.

Q6. Mitali, Indu and Geeta are partners sharing profits and losses in the ratio of 5:3:2. Geeta retires. Machinery of book value ₹1,50,000 is to be valued at ₹1,40,000; Patents of book value ₹30,000 are to be valued at ₹40,000; and Buildings of book value ₹1,00,000 are to be valued at ₹1,25,000. Prepare the Revaluation Account. [6 marks]

1. Machinery falls in value by ₹10,000 (₹1,50,000 − ₹1,40,000), so the Revaluation Account is debited with ₹10,000 and Machinery is credited with ₹10,000.
2. Patents rise in value by ₹10,000 (₹40,000 − ₹30,000), so Patents is debited with ₹10,000 and the Revaluation Account is credited with ₹10,000.
3. Buildings rise in value by ₹25,000 (₹1,25,000 − ₹1,00,000), so Buildings is debited with ₹25,000 and the Revaluation Account is credited with ₹25,000.
4. The Revaluation Account's debit side totals ₹10,000 and its credit side totals ₹35,000, leaving a net profit on revaluation of ₹25,000.
5. This profit of ₹25,000 is shared by all three partners in the old ratio of 5:3:2: Mitali gets ₹12,500, Indu gets ₹7,500, and Geeta gets ₹5,000.
6. The Revaluation Account is closed by debiting it with ₹25,000 and crediting Mitali's, Indu's and Geeta's capital accounts with their respective shares.

Q7. Distinguish between the accounting treatment of the amount due to a retiring partner and the amount due to a deceased partner. Give four points of difference. [6 marks]

1. Timing: retirement usually takes place at the end of an accounting year by mutual agreement, whereas death can occur at any time during the year, so the deceased partner's claim always needs a calculation of profit for an incomplete period.
2. Account to which the balance is transferred: the balance due to a retiring partner, if unpaid, is transferred to a retiring partner's loan account, whereas the balance due to a deceased partner is transferred to the deceased partner's executor's loan account.
3. Person entitled to the amount: the retiring partner himself receives the settlement, whereas the amount due to a deceased partner is paid to his legal representatives or executors.
4. Agreement on terms: a retiring partner can discuss and agree the mode and timing of payment with the continuing partners, whereas the terms for a deceased partner's settlement are normally fixed in advance by the partnership deed, since the partner is no longer available to negotiate.
5. In all other respects, such as adjustment of goodwill, revaluation of assets and liabilities, distribution of accumulated profits and losses, and interest on the unpaid balance, the accounting treatment is the same in both cases.

Q8. Evaluate the practice of transferring a retiring partner's unpaid dues to a loan account instead of paying them at once. Give two advantages and two limitations. [6 marks]

1. Advantage: the firm settles its obligation without disturbing its working capital all at once, since the cash outflow is spread over several years.
2. Advantage: the outgoing partner continues to earn interest on the unpaid balance, at the rate agreed in the deed or, failing agreement, at 6% per annum under the Indian Partnership Act, 1932.
3. Limitation: the loan account is a continuing liability shown in the Balance Sheet until fully repaid, which can make the firm's position look less liquid to creditors and bankers.
4. Limitation: the continuing partners must calculate interest accrued and due and interest accrued but not due correctly every year, which adds to the bookkeeping.
5. Overall, a loan account is suitable when the firm cannot raise the cash at once, but it should be used only when the deed or the partners agree to it, since the outgoing partner can insist on the agreed terms.

Key takeaways

• Retirement and death of a partner both reconstitute the firm, and the accounting treatment for settling the outgoing partner's claim is largely the same in both cases.
• If nothing is agreed otherwise, continuing partners acquire an outgoing partner's share in their old profit-sharing ratio, so the gaining ratio equals the old ratio.
• Goodwill is adjusted by debiting only the gaining partners' capital accounts, in their gaining ratio, and crediting the outgoing partner for his share of goodwill.
• Hidden goodwill is the excess of a lump sum settlement over the adjusted capital balance of the outgoing partner, even when goodwill is never separately valued.
• Accumulated profits, accumulated losses and revaluation profit or loss are always shared by all partners, including the outgoing one, in the old profit-sharing ratio.
• An outgoing partner's share of profit for the period up to retirement or death can be estimated on a time basis or a turnover basis, using past profits.
• Unpaid balances are transferred to a retiring partner's loan account or a deceased partner's executor's loan account, which must show interest correctly until fully repaid.
• The Balance Sheet on retirement or death must be prepared in the horizontal format only, and the Memorandum Revaluation Account and life policy methods are excluded.

Test yourself

What is the gaining ratio?

The ratio in which the continuing partners acquire the share of profit given up by the retiring or deceased partner.

How is hidden goodwill identified in a retirement problem?

It is the excess of the lump sum paid to the outgoing partner over the balance worked out in his capital account after all other adjustments.

In the old profit-sharing ratio or the new, are accumulated reserves and losses distributed on retirement?

They are distributed to all partners, including the outgoing partner, in the old profit-sharing ratio, because they relate to profits earned before the reconstitution.

Which account records an outgoing partner's share of profit for the period up to retirement or death, when the books are not closed mid-year?

The Profit & Loss Suspense Account, which is later closed against the gaining partners' capital accounts in their gaining ratio.

What right does Section 37 of the Indian Partnership Act, 1932 give a retiring partner if there is no agreement on his unpaid balance?

He may choose either interest at 6% per annum until payment, or such share of profits as has been earned using his money, based on the capital ratio.

To which account is the balance due to a deceased partner transferred?

To the deceased partner's executor's loan account, which records the amount owed to his legal representatives until it is paid off.

How is interest accrued but not due on a retiring partner's loan treated?

It is added to the loan balance and shown on the liabilities side of the Balance Sheet, since its payment date has not yet arrived.

In what format must the Balance Sheet be prepared on retirement or death of a partner?

In the horizontal format only, with liabilities shown on one side and assets on the other.