Partnership changes are a specific area of partnership accounting that deals with fundamental alterations to the structure or composition of the business. This topic is covered in Chapter 18 of the sources.
A partnership change occurs in several situations:
- When partners agree to change the way profits and losses are shared.
- When a new partner joins the firm, or an existing partner leaves.
- Upon the death or retirement of a partner.
A change in partnership is essentially treated as the end of one partnership and the commencement of a new one. The accounting procedures required in such an event involve ensuring existing partners are fairly compensated for past efforts and that the correct financial positions are established for the new arrangement.
1. Accounting for Profits and Losses
If a partnership change occurs partway through the trading year, the profit or loss for the entire year must be apportioned between the period before the change (the old partnership) and the period after the change (the new partnership).
Apportionment Rules
- Realised Profits/Losses: All realised profits and losses (such as revenue, cost of sales, and expenses recognized in the income statement) must be shared in the old profit/loss-sharing ratio up to the date of the change.
- Time Basis: Realised profits and losses are usually apportioned on a time basis, assuming revenue was earned evenly throughout the year.
- Exceptions: Certain items, such as interest on a partner's loan, must be apportioned on an actual basis rather than a time basis, especially if the loan terms or rates changed due to the new agreement.
- Post-Change Profits: Subsequent profits and losses must be shared using the new profit/loss-sharing ratio.
When a change occurs mid-year, separate income statements must be prepared for the old and new firms to show the accurate allocation of profit.
2. Revaluation of Assets
When a partnership changes (due to changes in profit-sharing ratios, admission, or retirement), partners may decide to revalue the assets and liabilities to reflect their current market value.
Purpose of Revaluation
The primary reason for revaluation is to reward the existing partners for their efforts in building up the business over its life. The partners' capital accounts would otherwise not show their true interest in the firm's net asset value.
Accounting Treatment
- Revaluation Account: A revaluation account is prepared to record the adjustments made to the asset and liability values.
- Unrealised Profit/Loss: The balance remaining on this account represents the profit or loss on revaluation, which is considered an unrealised profit or loss.
- Transfer to Capital Accounts: Any profit or loss on revaluation is shared among the partners in their current profit-sharing ratio (the ratio in place before the change) and transferred to the partners’ capital accounts.
- Capital vs. Current Accounts: The profit/loss is always entered in the capital accounts, not the current accounts. If the partners drew out an unrealised profit (a non-cash adjustment) from the current accounts, the business could suffer financial difficulty as cash would be leaving the business without an equivalent realized gain.
3. Accounting for Goodwill
Goodwill is defined as the amount by which the value of the partnership as a going concern exceeds the net value of its assets if they were sold separately. Goodwill must be accounted for whenever there is a change in the partnership, such as altering profit-sharing ratios, or admitting/retiring a partner.
Partners often decide not to open a goodwill account because its value is subjective and difficult to justify, and showing it in the Statement of Financial Position might discourage future purchasers from paying more if the value increased.
Method when No Goodwill Account is Opened
If partners decide not to show a goodwill account in the books, the objective is to adjust the capital accounts so that the partner whose future profit share (and thus future goodwill share) is decreasing is compensated by the partner(s) whose share is increasing.
The procedure involves adjusting the partners' capital accounts (never their current accounts):
- Credit the partners' capital accounts with their share of goodwill calculated using their old profit-sharing ratio.
- Debit the partners' capital accounts with their share of goodwill calculated using their new profit-sharing ratio.
A partner who loses a share of goodwill is credited, while a partner who gains a share of goodwill is debited. This process ensures the partners who built up the goodwill are rewarded for their efforts.
4. Partner Admission or Retirement
When a new partner joins or an existing partner retires, the accounting procedures already described (revaluation and goodwill adjustments) must be completed.
- Admission: When admitting a new partner, the profit or loss on revaluation, as well as the adjustment for goodwill, is made to the capital accounts of the existing partners using their old ratio before the new partner's ratio is applied.
- Retirement: When a partner retires, the final balance on the retiring partner's current account must be transferred to their capital account. The final balance on the retiring partner's capital account is then closed, either by being transferred to a loan account (if they leave capital in the business) or paid out in cash.
5. Dissolution of a Partnership
A complete dissolution of a partnership is a more drastic change, meaning the business ceases trading entirely, assets are sold, and liabilities are paid off.
To account for dissolution, a Realisation account is prepared:
- All assets to be sold are debited to the Realisation account at their book values.
- All liabilities to be paid are credited to the Realisation account at their book values.
- Proceeds from the sale of assets (money received) are credited to the Realisation account and debited to the bank account.
- Payments for liabilities are debited to the Realisation account and credited to the bank account.
- The profit or loss on dissolution is transferred to the partners' capital accounts based on their profit-sharing ratios.
- Balances on current accounts are transferred to the capital accounts.
- Finally, the capital accounts are closed by transferring the final balance to or from the bank account.
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