Reconstitution: Change in Profit-Sharing Ratio

A partnership is reconstituted whenever the existing partners change their mutual rights — the simplest case being a change in the profit-sharing ratio (PSR) among the same partners. When the ratio changes, one or more partners gain a share and others sacrifice a share. Identifying who gains and who sacrifices is the first and most important step.

• Sacrificing Ratio = Old Share − New Share (when positive, the partner has sacrificed).
• Gaining Ratio = New Share − Old Share (when positive, the partner has gained).

Worked example. A and B share profits 3:2 and decide to share equally (1:1) in future.

• A: old 3/5, new 1/2 → 3/5 − 1/2 = 6/10 − 5/10 = 1/10 sacrifice.
• B: old 2/5, new 1/2 → 1/2 − 2/5 = 5/10 − 4/10 = 1/10 gain.

So A sacrifices 1/10 of the profits to B, who gains 1/10. The partner who gains must compensate the partner who sacrifices — mainly for goodwill, covered next. A handy check: the total sacrifice always equals the total gain. Getting the sacrificing/gaining ratio right is essential, because the goodwill adjustment is shared in exactly this ratio.

When the ratio changes, the goodwill already built up belongs to the old partners in the old ratio. The partner who now gains a share is effectively buying part of that goodwill from the partner who sacrifices. So an adjustment entry is passed, without raising a goodwill account (AS-26 bars self-generated goodwill in the books):

Gaining Partner's Capital A/c  Dr
   To Sacrificing Partner's Capital A/c

The amount = firm's goodwill × the share gained/sacrificed. For example, if goodwill is valued at Rs 60,000 and B gains 1/10 from A, then B's capital is debited and A's capital credited with 60,000 × 1/10 = Rs 6,000.

Next, any accumulated profits, reserves and losses (general reserve, profit & loss balance, workmen compensation reserve, etc.) standing in the balance sheet also belong to the old partners in the old ratio. So they are distributed to the partners' capital accounts in the old ratio before the new ratio takes effect:

• Reserves and accumulated profits → credited to old partners in the old ratio.
• Accumulated losses (e.g. a debit P&L balance) → debited to old partners in the old ratio.

The principle behind both adjustments is the same and worth memorising: everything earned or built up before the change belongs to the partners in the OLD ratio. Only future profits will be shared in the new ratio.

On reconstitution, the assets and liabilities may not be at their true current values. Any resulting profit or loss belongs to the old partners (it arose under the old arrangement), so we revalue them through a Revaluation Account (also called the Profit & Loss Adjustment Account).

The rules for the Revaluation Account:

• An increase in an asset or a decrease in a liability is a gain → credited to Revaluation.
• A decrease in an asset or an increase in a liability is a loss → debited to Revaluation.
• Any unrecorded asset brought in is a gain (credit); any unrecorded liability is a loss (debit).

The balance of the Revaluation Account is the net revaluation profit or loss, transferred to the partners' capital accounts in the old ratio. For example, if a building rises by Rs 40,000 and a provision for doubtful debts of Rs 5,000 is created and creditors are overstated by Rs 3,000 (a gain), the net effect is a credit balance (gain) shared in the old ratio. With the ratio, goodwill, reserves and revaluation all settled, the partners' capital accounts are brought up to date — and the same toolkit will handle the bigger events of admission, retirement and dissolution.