Revise Partnerships: Changes and Dissolution for Cambridge 9706 (3.1.2)

Goodwill is an intangible asset representing the value of a business's reputation, customer base, and other non-physical attributes that give it a competitive edge. In partnerships, goodwill becomes a crucial calculation when the structure changes, as it represents value built up by the existing partners. There are two types:

For partnership changes, we deal with inherent goodwill. The modern accounting treatment is the 'memorandum revaluation' method. Goodwill is calculated, credited to the old partners' capital accounts (in the old PSR), and then immediately written off by debiting all partners' capital accounts (in the new PSR). The net effect is a transfer of capital from new/gaining partners to old/sacrificing partners, without goodwill remaining on the books.

When a partnership's structure changes, it's only fair that the assets and liabilities are stated at their current, fair values. The Revaluation Account is a temporary account used to record these adjustments. Any increase in the value of an asset (or decrease in a liability) is a gain, and any decrease in an asset's value (or increase in a liability) is a loss.

The final balance on the Revaluation Account, the 'Profit or Loss on Revaluation', is shared among the partners.

Important: This profit or loss is shared by the old partners in their old profit-sharing ratio (PSR), as they were the ones who owned the assets during the period of value change.

Partnership agreements can change for several reasons. The main scenarios you need to master are a change in the profit-sharing ratio, the admission of a new partner, and the retirement of an existing partner. Each event triggers a similar sequence of accounting adjustments to ensure fairness.

Partners may decide to alter their PSR due to changes in their contributions of time, effort, or capital. When this happens, the partnership's assets are revalued and goodwill is accounted for. The gains/losses on revaluation and the goodwill adjustments are credited/debited to the partners' capital accounts to reflect the value they had built up under the old ratio before the new one takes effect.

A new partner is often admitted to bring in more capital or expertise. The accounting procedure involves:

1. Revaluing existing assets and liabilities via the Revaluation Account. The profit/loss is shared between the old partners in their old PSR.
2. Accounting for goodwill. The value of goodwill is credited to the old partners (old PSR) and then written off by debiting all partners, including the new one (new PSR).
3. Recording the capital brought in by the new partner (Debit Bank, Credit New Partner's Capital Account).
4. Preparing a new statement of financial position with the updated asset values and new capital balances.

When a partner retires, they are entitled to their share of the partnership's value. The process is similar to an admission:

1. Revalue assets and liabilities, sharing the profit/loss among all partners (including the retiring one) in the old PSR.
2. Account for goodwill, with the retiring partner receiving their share.
3. Calculate the total amount owed to the retiring partner. This is the final balance of their capital and current accounts after all adjustments.
4. The payment is recorded (Debit Retiring Partner's Capital Account, Credit Bank). If payment is delayed, the amount is transferred to a Loan Account in the partner's name, which becomes a liability of the partnership.

If a partnership change occurs part-way through the financial year, you must prepare the financial statements carefully. The Statement of Profit or Loss is prepared for the full year, but the Appropriation Account needs to be split. You will calculate the profit for the period before the change and the period after the change. Partner salaries, interest on capital, and profit shares will be calculated separately for these two periods, often using different PSRs and capital balances. This requires careful, pro-rata calculations.

Dissolution is the complete termination of the partnership. The business ceases to trade, and the accounts must be closed. This process is managed through a Realisation Account. Unlike a Revaluation Account, which adjusts values, a Realisation Account is used to close all asset and liability accounts and determine the final profit or loss on the sale of the business.

Steps for dissolution using the Realisation Account:

1. Transfer all assets (except cash/bank) to the debit side of the Realisation Account at their book value.
2. Transfer all liabilities to the credit side at their book value.
3. Record cash received from selling assets on the credit side (and debit Bank).
4. Record cash paid to settle liabilities on the debit side (and credit Bank).
5. Record any dissolution expenses on the debit side.
6. The final balance is the Profit or Loss on Realisation, which is shared among all partners in their final PSR.

$\text{Realisation Account} \\ \begin{array}{c|c} \hline \text{Debit} & \text{Credit} \\ \hline \text{Assets (at book value)} & \text{Liabilities (at book value)} \\ \text{Bank (payment of liabilities)} & \text{Bank (sale of assets)} \\ \text{Bank (realisation expenses)} & \text{Loss on Realisation} \\ \text{Profit on Realisation} & \text{(transferred to Capital a/cs)} \\ \text{(transferred to Capital a/cs)} & \\ \end{array}$